Remind Me Again, What's a Bubble?

Hey, we've all heard this for over a year now. Basically, the last decade was this debt-fueled rave party redux of the roaring twenties. There was so much credit available to anyone with a pulse that businesses and individuals went on a wild spending spree, leveraged to the gills, pigging out on everything left right and center. Profits exploded as cash registers rang out like Christmas morning bells, magnified by layer upon layer of leverage. This, we are told, is the essence of a credit bubble.

And this bubble has popped. There is less credit available now, and we are at the end of an epoch. Spending will drop, profits will drop, and the effect of leveraged returns will diminish. We are, in short, entering an era of lower profits and looking at the past decade for evidence of future earnings power on equities is folly.

There must be at least some truth to this story line, but the belief in this story is so pervasive, you almost have to question its validity. What I am getting at is this. The thing is, what makes a "bubble" is not too much quantity of an asset, but rather, a market failure to appropriately price that asset relative to its risk. Were there too many tech companies during the dot-com bubble? Maybe, but the real nub of that debacle was that people would pay anything for a tech stock, risk be damned.

This says something important about the “debt bubble” we keep hearing about. What if the problem was not too much debt sloshing around the system, but instead, the debt was under-priced relative to its risk? If so, then that says something about what the long term effects of this bubble would be.

Under this analysis, it would not follow necessarily that there will, going forward, be less debt out there. Under this analysis, it would simply cost more as investors demand higher interest. And if so, what does that say about corporate earnings? Answer? Well, there is none. If consumers have to spend more on interest, maybe they borrow less and buy fewer things. Or they shift their consumption patterns. Maybe instead of spending, they save more. Whether they spend or save, though, the money is there in the system, producing profits for retailers on the one hand, or deposit taking banks on the other. I doubt it would be easy to predict which of retailers or banks gets the largest slice of the pie in this scenario, but as long as the money gets put into the system (rather than under the mattress), that pie is growing and. A growing pie equals growing earnings because in the game of capitalism, no piece of pie goes unc... for long.

So, what is the practical upshot for investors? Here’s my take. If I assume the outcome of the debt bubble is that interest rates are going up (because people want to be paid more these days for taking on risk), I might look at the ten year treasury yield (for instance) and assume that it will rise over the next many years. Would this benefit or harm stock returns?

You’d think it would hurt stock returns because you’re going to apply a higher discount rate when you derive the net present value of future earnings. But when you chart the S&P 500 against the ten year treasury yield, you draw another conclusion. Instead, over the last ten years, when interest rates are falling, it seems that the S&P 500 tends to fall as well. Why? Probably because people are dumping stocks and shifting their wealth into bonds. And on the converse side of things, when yields are rising, it seems the S&P 500 can rise in tandem. Why? Probably because folks are dumping bonds and shifting their money over into stocks.

A bursting debt bubble sounds pretty horrible if you're a stock investor at first blush - and we're hearing plenty of first blushes. But on further reflection, it may actually not be such a bad thing for equity investors in the least. I don't know the answer to that conundrum. But what I do know is that investors ought to ask themselves: &quot... are my assumptions about the nature of what a "bubble" actually is in the first place?" Do that, and your conclusions as to the likely impact of a credit bubble&amp... may (or may not) change. Possibly diametrically.

Comments

[Gem Hudson:]

Emporer Alexander Severus by shaving more silver off their coinage kept his soical order by paying his troops a one quarter more and double the base pay and any more of these accession bonus was to put more bronze than gold into their coinage. 1 pound of gold would not equal 40 gold aurei or 1000 denarii and start bartering not exchange for trade goods for value but goods for goods and service for service and there version of hyperinflation was what broke up the empire.

May 29 09:11 AM

[lbsterling:]

I'm all in favor of thinking about things in a new light, so I like the opening section of your article:
That the problem was mispriced debt rather than too much debt has the ring of truth.

But top to bottom I'd say your further analysis has too many flaws to be useful.

"Under this analysis, it would simply cost more as investors demand higher interest. And if so, what does that say about corporate earnings? Answer? Well, there is none. If consumers have to spend more on interest, maybe they borrow less and buy fewer things."

Higher interest rates during a downturn will be crushing, that's the "checkmate" scenario. Corporations will have trouble financing investments, and consumers, as you yourself suggest in the quote, won't be able to consume until deleveraging has run its course.

Hence the Fed's efforts to keep rates low.

Further, I think it's say that the relationship between yields and the S&P in the past 10 years is not going to be very useful for what happens in the next 10 years.

Finally, someone else above pointed out, a lot of the money IS gone _ and the Fed is working hard to re-create it, with results that are as yet unknown.

So thanks again for the article _ I will be curious to see how your thinking develops.

May 29 09:33 AM

[Tony Petroski:]

Mr. Trias: Your first paragraph was outstanding.

Keep thinking, you have some good ideas.

Clean up your last three paragraphs.

May 29 11:13 AM

[John Lounsbury:]

Alex - - -

Great article. It is good because of what it says and also for what it fails to say. There are also some points you make that may be based on debatable premises, which creates some strong discussion, as found in the comment stream.

Some of the things that caught my attention include:

1. You said "...but as long as the money gets put into the system (rather than under the mattress), that pie is growing and. A growing pie equals growing earnings because in the game of capitalism, no piece of pie goes unc... for long."

This implies the value of an expanding monetary base. In fact, the value of such expansion is debatable. Increased velocity of money, as pointed out by six, is far more important, and much preferable, to increasing the amount of printed currency. What is not widely recognized is that, in our fractional reserve banking system, a dollar saved (in a bank, an annuity, etc.) has a multiplier effect much larger than many of the ways that a dollar can be spent. Take, for example, a 10% reserve system. The velocity multiplier effect of a dollar deposit can be up to 10. The multiplier effect for a dollar spent is often much smaller, especially when spent on consumption.

If any of the saved dollars results in loans that increase the means of production of things of utility, those lent dollars can have a velocity multiplier much greater than unity, say 3. So the velocity factor for these dollars saved and thus lent would be 30. And the result would be the greater wealth of society because the production continues for years.

Compare this with the misuse of credit for non-productive purposes (other than the creation of financial wealth of some charletans) that we have allowed to be compounded over the past few decades.

2. Harry Tuttle points out the shortcoming of comparing the decoupling of bond and stock returns over the past ten years. In the 20 years before 2000 these two returns were highly correlated. Your explaination of what happened over the past decade is correct (investors moving money out of bonds and into stocks, and then back the pther way again) but there are extended periods when that action does not affect the valuation levels of the two asset classes.

3. lbsterling makes some great points further about the affects of interest rates.

4. The insatiable appetite (so far) of the deep pit of overleverage to absorb the Fed and Treasury attempts to recreate liquidity (read I need more cowbell's comment) will, at some point, hit the wall. If the presses keep running, that will mark the point at which something else (foul smelling excrement) hits the wall.

5. All commenters I have not mentioned above, you have made this a great discussion to read. Thanks.

Alex, you have taken a profound topic and written a good article, made great by the comment stream.

May 29 11:19 AM

[xmichaelx:]

Bubbles are the financial manifestation of groupthink. Right now, the groupthink is "Oh NOES THE SKY IS FALLING!!!1!" So banks aren't lending, consumers aren't buying, businesses are laying people off, etc. The ridiculous bear bubble will pop just like all others do, and the market will begin making sense again, and those of us who've invested against the bubble -- buying stock in strong companies for next to nothing -- will make out like bandits. Some of us have already seen amazing gains over the past 6 months.

May 29 01:23 PM

[Fighting Yoda:]

If it looks like a duck...

Bubbles are "irrational exuberance", "animal spirits". Any significant deviation from mean is a bubble. What is bubble - it is just a Ponzi scheme - early entrants get paid by later entrants, last ones are left holding the baby. Well ultimately we have the bust and things revert back to mean, there is huge fallout, solution conceived is the next bubble.

Unfortunately our system is designed to create and maximize bubbles. We have a phony economy as Peter Schiff states- "borrow and consume economic model".

We have to get back to basics Econ 101 - Save -> Invest -> Produce -> Consume. But our Govt. and corporate leaders don't get it - they think creating bubbles is an easy way out. This whole strategy was invented by the maestro Greenspan, we will keep suffering till we radically change the American ways- consuming is the most patriotic duty.

May 29 01:27 PM

[morph366:]

Fighting Yoda

Your diagnosis is correct about the Ponzi scheme but who's going to investigate it and how do we end it?

May 29 02:07 PM

[Alex Trias:]

Yes, I'm perplexed by the yield curve. Generally, a steep curve indicates boom times ahead. But with all this Fed buying of Treasuries, there is some severe noise baked into the curve. In the context of quant. easing, what does our historic spread between short and long term Treasuries actually SAY? I'm not sure yet.


On May 29 05:08 AM punk_ash wrote:

> Good thoughts. A rising yield curve generally means boom times.
> However, many people will be shifting money to annuities this time
> around, which leaves money right into fixed income.

May 29 02:46 PM

[Alex Trias:]

Wealth destruction? I argue there is none. When markets crash, wealth is neither created nor destroyed, but simply transferred from buyers to sellers.


On May 29 09:00 AM I need more cowbell wrote:

> "Whether they spend or save, though, the money is there in the system,
> "
> No, its not. How can you ignore the wealth destruction, to date in
> US around $15-20T alone, worldwide much higher? This is the core
> reason velocity has cratered, along with the seachange in attitides-
> no one wants to borrow, they want less debt, not more.

May 29 02:49 PM

[thiazole:]

You mean that we need to become like Japan? tinyurl.com/pjdkhq

There are dangers to both sides. The real economy is production of goods that people want or need to consume. Everything else is just a way of accomodating that. Currency is medium for trade, not something to be saved for the sake of saving. If you are going to save something, it should be a commodity or something else with intrinsic value.


On May 29 01:27 PM Fighting Yoda wrote:

> We have to get back to basics Econ 101 - Save -> Invest -> Produce
> -> Consume. But our Govt. and corporate leaders don't get it - they
> think creating bubbles is an easy way out. This whole strategy was
> invented by the maestro Greenspan, we will keep suffering till we
> radically change the American ways- consuming is the most patriotic
> duty.

May 29 02:52 PM

[ain't no fo...:]

Alex, would THIS be a bubble???????????

usdebtclock.org/

May 29 02:56 PM

[tuckfinitee:]

How should the bondholders of Chrysler or GM have priced risk? Do you have any suggestions for Bradford and Bingley bondholders? Something has definitely emerged from the bail outs and bankruptcies. The risk gap between insiders with political power and outsiders. I'm not loaning money in the US or Europe.

I believe a lawyer was quoted as saying Chrysler needs employees, they don't need the bondholders. Price that.

May 29 03:11 PM

[Dave Wrixon:]

Yep, the bankruptcies of GM and Chrysler may get one or two people of the hook, but the damage to corporate investment in the US is immeasurable. Who the hell would buy corporate bonds. As from today all corporate bonds are junk!


On May 29 03:11 PM tuckfinitee wrote:

> How should the bondholders of Chrysler or GM have priced risk? Do
> you have any suggestions for Bradford and Bingley bondholders? Something
> has definitely emerged from the bail outs and bankruptcies. The risk
> gap between insiders with political power and outsiders. I'm not
> loaning money in the US or Europe.
>
> I believe a lawyer was quoted as saying Chrysler needs employees,
> they don't need the bondholders. Price that.

May 29 05:42 PM

[Dave Wrixon:]

Or in recent days from Americans to Non-Americans.


On May 29 02:49 PM Alex Trias wrote:

> Wealth destruction? I argue there is none. When markets crash, wealth
> is neither created nor destroyed, but simply transferred from buyers
> to sellers.

May 29 05:44 PM

[Dave Wrixon:]

Defining a bubble is easy. It is an unsustainable expansion of market capitalization. Identifying them is a little more difficult, as we need to determine what what make them unsustainable. The really tricky part, however, is knowing when they will implode. Ever more sophisticated investment strategies make it perfectly acceptable to participate in market bubbles, in the firm and often mistaken belief that the implosion can be predicted and hence avoided. The end game is often little more than enormous game of Chicken. But never fear, the dollar rout is in full swing so bubbles will not be an issue. Sure prices will go up but the only unsustainability will be in the currency.

May 29 05:56 PM

[Fighting Yoda:]

You don't have to sell for your asset to depreciate - it is the market value.


On May 29 02:49 PM Alex Trias wrote:

> Wealth destruction? I argue there is none. When markets crash, wealth
> is neither created nor destroyed, but simply transferred from buyers
> to sellers.

May 29 07:44 PM

[morph366:]

Re: Author's comment
Wealth destruction? I argue there is none. When markets crash, wealth is neither created nor destroyed, but simply transferred from buyers to sellers.

This comment strikes me as intuitively wrong but please enlighten me if you think that the following is mistaken

Does wealth equate to value in your estimation? If so then in what sense has there not been value destruction of the assets on bank's balance sheets and the inter-related valuation of residential/commercial real estate?
Market valuations (in a non rigged system such as M2M) should be based upon transactions on the margin and right now they are showing dramatically reduced implied market capitalization for most asset classes - that is value destruction and not transfer.
To take just one topical example - who were the beneficiaries of the loss of value in GM equity which would allow you to call it a zero sum game?

May 30 05:10 AM

[Dave Wrixon:]

Well in GMs case the value has been sucked out by it workforce (including managers) and dealers over the years, and we are talking decades. That money will have been recycled and probably ended up getting spent on a Toyota in many instances.

On May 30 05:10 AM morph366 wrote:

> Re: Author's comment
> Wealth destruction? I argue there is none. When markets crash, wealth
> is neither created nor destroyed, but simply transferred from buyers
> to sellers.
>
> This comment strikes me as intuitively wrong but please enlighten
> me if you think that the following is mistaken
>
> Does wealth equate to value in your estimation? If so then in what
> sense has there not been value destruction of the assets on bank's
> balance sheets and the inter-related valuation of residential/commercial
> real estate?
> Market valuations (in a non rigged system such as M2M) should be
> based upon transactions on the margin and right now they are showing
> dramatically reduced implied market capitalization for most asset
> classes - that is value destruction and not transfer.
> To take just one topical example - who were the beneficiaries of
> the loss of value in GM equity which would allow you to call it a
> zero sum game?

May 30 05:18 AM

[Crocodilian:]

On May 29 02:49 PM Alex Trias wrote:

> Wealth destruction? I argue there is none. When markets crash, >wealth is neither created nor destroyed, but simply transferred from >buyers to sellers.
----------------------...

sometimes true, sometimes not. A true statement if we're speaking of a cash transaction: I sell (or sell short) my shares to you, stock goes down, my gain is precisely offset by your loss.

But what happens if I borrow against the value of my house in 2006 based on a mistaken assumption about how much money I'll be earning and the house will be worth in 2009?

There may well be offsetting gains in this scenario-- but they're displaced in time, that is, we consumed more in 2006, and were richer then . . . but there is no offsetting gain today. An argument can be made that wealth hasn't been "destroyed" per se, that we just discovered that it wasn't there, I suppose.

And it can be worse than that: if the nation's financial problems become acute, as they have, we can end up producing far below capacity. . . this "slack" is wealth that is lost forever, with no offset. That is, a skilled tool and die worker who's not performing his trade represents wealth lost to the economy forever.

May 30 05:00 PM

[Fighting Yoda:]

"bubble is a bigger truth built around a smaller truth". No bubble is simply a big lie built around a small truth


On May 29 06:15 AM User 353732 wrote:

> All bubbles are caused by the suspension of logic(i.e the spectacular
> succcess of the recent past can be extrapolated into the indefinite
> future even tho' experience and observation tell us this never happens)
> in the pursuit of undeserved gain(i,e showing up is enough; participation
> ensures profit). Commodity bubbles in their later stages typify this.
>
> In the bandwidth/internet bubble , investors were led to believe
> and were eager to believe that spectacular growth on a very small
> base would continue to result in spectacular growth on a much bigger
> base and therefore valuations could not catch up with this parabolic
> curve.Hence buying at any price was fine since the price would be
> higher tmrw. This was also true of the Enron( asset light, merchant/trading
> operations) category of bubble.
> In the real estate bubble, the belief that a brief period of astonishing
> price appreciation fueled by a combination of almost free money ,no
> credit discipline, unprecedented transactional activity/frenzy and
> blatant fraud was based on fundamental shifts rather than serial
> and stacked illusions meant that the mere act of owning any property,
> anywhere at virtually any price was enough to ensure great capital
> gains with no risk at all.
> The Treasury Debt bubble is based on the illogical belief that the
> very entity(the Govt) that is systematically destroying both economic
> liberty and safety can itself be a riskless source of economicsafety
> and liberty(the undeserved gain people seek here is reliability in
> the obviously unreliable and integrity in the manifestly corrupt).
>
> The reason momentum investors often profit from bubbles and other
> investors, specially retail investors, get badly hurt is that the
> former understand what a bubble is based on and the latter do not.
> Momentum investors flee at the first sign of trend reversal because
> they know truth is about to shred illogic and illusion while other
> investors increase their exposure convinced that "a dip is a buying
> opportunity" or that a trend reversal is a transient abberation.
>
>
> Momentum investors( many of them, not all, but those who have done
> their homework and respect experience) know that the bubble is a
> very big lie built around the core of a very small truth.
> Retail investors are convinced a bubble is a bigger truth built around
> a smaller truth.......and somehow only they are blessed with this
> unique insight.

May 30 11:56 PM