WHY THIS BUBBLE BUST IS NO DIFFERENT THAN PAST BUBBLE BUSTS
Why do bubbles form and why do markets crash? Both are intriguing questions and both are the result of the inefficiency of human psychology. The cornerstone of my investment approach lies in one core belief: through the study of human psychology we can come to the conclusion that humans are irrational creatures. Put 1 million humans in a room with blinking lights, ever changing prices and money on the line and you have a recipe for mass hysteria.
While it’s a nice thought that we are far removed from the rest of the animal kingdom, it’s simply false that humans won’t do just about anything to survive and to ensure the future well being of the species. This is nowhere more apparent in everyday life than it is in the stock market. It’s one of the primary reasons why the market is so fascinating. It cuts to the core of every survival instinct we have while challenging your mind in the most interesting and complex ways.
The summation of the thoughts of the participants struggling to control these survival instincts creates a highly unstable environment – one which is chaotic in nature. Therefore, this non-linear dynamical system is susceptible to inefficiencies - just like any chaotic system. Contrary to popular opinion, the summation of irrational thoughts does not result in a highly efficient market. In fact, it results in a highly inefficient market – particularly in the near-term. A beautiful quote in a BNP research piece summed this up nicely with an example:
When interacting agents are playing in a hierarchical network structure very specific emerging patterns arise. Let us clarify this with an example. After a concert the audience expresses its appreciation with applause. In the beginning, everybody is handclapping according to their own rhythm. The sound is like random noise. There is no imminence of collective behavior. This can be compared to financial markets operating in a steady-state where prices follow a random walk. All of a sudden something curious happens. All randomness disappears; the audience organizes itself in a synchronized regular beat, each pair of hands is clapping in unison. There is no master of ceremony at play. This collective behaviour emanates endogenously. It is a pattern arising from the underlying interactions. This can be compared to a crash. There is a steady build-up of tension in the system (like with an earthquake or a sand pile) and without any exogenous trigger a massive failure of the system occurs. There is no need for big news events for a crash to happen.
Financial markets can be classified as open, non-linear and complex systems. They also exhibit emanating patterns as a result of which the “invisible hand” can be very shaky. More then 40 years ago Benoit Mandelbrot described the fractal structure of cotton prices and the emanating properties of fat tails and volatility clustering and Hyman Minsky proposed a theory for endogenous speculative bubble formation. More recently Robert Shiller and Alan Greenspan made the irrational exuberance paradigm fashionable. These all fit in the framework of Complexity Economics, which describes the properties that emerge from interacting agents. It has become clear that herding behaviour in financial markets results in positive or negative feedback mechanisms causing price accelerations or decelerations and (anti)-bubble formation, where asset prices become detached from the underlying fundamentals
Using a chart courtesy of Dshort.com I was able to piece together some of the most famous bubbles from the last 75 years that summarize, visually, how chaotic and irrational markets can be. The fundamentals are generally the same in each scenario – supply glut combines with soaring demand which eventually blows off resulting in a collapse in demand, high supply and crashing prices. The psychology is generally the same as well. Fear and greed drive the gyrations, but the fundamentals always rule the long-term price action. The gyrations are fascinating as investors drive prices higher in a euphoric sprint for the cliff. As the herd collapses over the cliff, investors struggle constantly, trying to catch the falling knife while convincing themselves that the bottom bottom has been reached. The result in the long-term, however, is generally the same. Falling demand and high supply lead to sideways or falling prices for years to come as investors slowly lose their resolve and appetite for risk. I’ve included the oil bubble, Shanghai bubble, collapse in bank stocks and the U.S. housing bubble for reference:
When humans act irrationally for years and years (as we have during this 25 year credit binge) it’s natural to expect a long and drawn out recovery or digestive period. The likelihood of a v-shaped recovery is very low based on the strong long-term fundamental forces at work (think deleveraging). Of course, it could be different this time and the Fed could reflate us back to the bubble days – in which case, we’ll likely suffer another relapse in the next decade because we refused to take our medicine the first time around (which we have). Sir John Templeton once said that the four most dangerous words in investing were “it’s different this time”. Is it different this time? You never know – humans do, after all, have a knack for the irrational. Looking at the history of bubbles and and bubble psychology, however, doesn’t make me feel too confident about betting on it….
Excellent post TPC.
I generally agree with you about bubbles, but I would argue that they are actually built upon rational components and that they can become easier to understand if we can see this.
Bubbles occur when the effort to achieve above-average returns results in excessive capital being invested in a given segment to the point that market prices exceed intrinsic value. It’s human to like easy money, and every portfolio manager likes to believe that he can outperform the averages even though by definition, only a minority can outperform the average. By definition, the majority will be at or below the average, but that statistical fact doesn’t prevent most of us from trying to be the exception.
Just about every bubble began with some decent fundamentals to support them. That’s important to recognize, because those beginning fundamentals will usually provide the basis for the buy story that will carry the market to inefficient levels. That’s the same story that will be recited by the pundits in the financial media and brokerage business, and repeated by the dumb money at dinner parties. We saw this with housing, the internet, oil and just about everything else — there was generally some fundamentals-based rationalization that makes the whole thing sound reasonable at the time to those who accept the popular view.
Basic economic theory tells us that markets should generally work their way toward equilibrium — high prices due to surging demand should attract new suppliers to a market, which results in prices eventually falling. So barring some extraordinary major macro permanent event, a dramatic price increase over a short period of time is probably not sustainable, because prices in a functioning market generally have no good reason to rise dramatically. When prices skyrocket, as was the case during the oil bubble, that’s the time to be wary, because there is rarely a good reason for something like that to occur.
Basic economic theory does not tell us something that is should, namely that leverage impacts pricing. If anything, it suggest that leverage or deleveraging have no impact on pricing at all, which of course is terribly wrong. If you want to know why economists missed this whole thing, this is probably the reason; they generally ignore the impact of debt.
If we understand these points, bubbles will be seen as they are, not as some sort of weird aberration or indication of a world gone mad, but as a normal occurrence that occurs because of perfectly human inclination to outperform. Combine this with the general lack of institutional memory, and you end up with bubbles being replicated unless they are regulated out of existence, as individuals don’t tend to learn their lessons. Over time, I would expect this phenomenon to accelerate, because technology has sped up the information flow that feeds bubbles and because we have fundamentally higher levels of credit and leverage in our system than we used to.
I personally see another housing bubble occurring within the next decade or so, because housing is the easiest way to transfer a large quantity of appreciating assets into the hands of the average consumer, who has become such an important part of developed economies. When your friends start wisely advising you at parties that “they can’t build more land,” you’ll know that the bubble is well underway again.
@ Angry MBA – I generally agree w/ your comments except your claim “and every portfolio manager likes to believe that he can outperform the averages even though by definition, only a minority can outperform the average. By definition, the majority will be at or below the average, but that statistical fact”
Actually 50% will be above average and 50% below average; perhaps your claim is that over a long duration observation period only the minority will be able to beat average consistently is what you intended.
I like your comment re: “institutional memory”; I also believe that this is fed by the U.S. (and global) speculative culture; it seems everyone moreso enjoys the tale of speculative profits, however due to ego ignore the speculative losses.
While i agree with your cocktail party originations of another bubble; I do not see it w/in 10-years…i do know that it will occur again in our lifetime and the recipe for success is to find the funding enterprise and take a highly levered, calculated out-of-the-money put position for max profit (i.e. subprime origination shops).
I wonder if he meant “immanence”.
Actually 50% will be above average and 50% below average
When I refer to “average”, I’m not speaking of the exact mean, but of a narrow range on either side of the mean. In effect, I’m dividing the world into three camps (average, below average, average average) and labeling those who are close to the mean as being “average,” even if they are nominally above or below the mean.
Assuming a typical bell curve, most people will naturally fall into the first two camps. But if we wish to be more precise in our language, then yes, you are accurate.
Nice thoughts everyone. Hopefully this wasn’t too wonkish.
MBA, I am beginning to wonder myself if China isn’t another bubble in the making. It would seem that the fundamental landscape is there and if Europe and USA continue to be capital unfriendly locations China is going to become the no-brainer in the coming decade. I don’t think housing will explode to the upside again. I think that was a baby boomer driven event and that this generation of wealthy Americans has learned their lesson. I know my parents will never buy a house again….
China is a huge bubble waiting to burst, but they will turn to war at that point. imho.
I read something the other day on CHS’s blog about bubble psychology that was interesting. Basic premise is that our collective tendency to jump on the bandwagon during mania phases was more of a survival instinct than anything else. Thousands (hundreds?) of years ago, when times were good, we ate ourselves sick and indulged when the getting was good, because you didn’t know when you were going to eat again.
http://ibankcoin.com/cronkite/2009/07/15/editorial-behavior-of-an-oligarchy/
Taibbi’s article, while good, is 50% speculation and 50% fact. Goldman isn’t entirely good, but blaming all of these “bubbles” on them is just plain wrong. Anyone who believes that U.S. consumers weren’t willing buyers of the bubble fever during the Nasdaq bubble and the housing bubble are wrong. So Goldman sold them the product that fed their addiction. Last time I checked the products they were selling weren’t illegal. Perhaps it’s not ethical or “right”, but that doesn’t make them liable for the problems.