Interest In Bubbles Makes them Disappear - Like Magic
There comes a time in every bubble's life when participants who have a stake in its continuation have to employ ever more tortured logic to justify sticking with it. We have come across an especially amusing example of this recently. "Good news!" blares a headline at CNBC "Bubble concern is at a 5-year high". Ironically, since at least 1999 if not earlier, the source of this headline has been referred to as 'bubble-vision' by cynical observers (or alternatively as 'hee-haw'). Let us take a look at what is behind this 'good news' announcement:
"People are more interested in the concept of a "stock bubble" than they've been at any time since the housing bubble collapsed. But ironically, that very concern could be what prevents another bubble from forming anytime soon.
According to Google Trends, worldwide search interest in the term stock bubble is higher in November 2013 than in any month since October 2008. The rise in interest is even more pronounced in the United States, where in data going back to 2004, the volume of searches for the term is the highest it's ever been (with the exception of the bubble-period around November 2007.)
Paradoxically, many market participants say this should actually calm those who fret that equities are currently in a bubble. "That means, conclusively, that there is no stock bubble," Jim Iuorio of TJM Institutional Services told CNBC.com. "It means that people aren't caught up in the hysteria of being deluded that there is no bubble, which is the only way that a bubble can exist."
Mark Dow, a former hedge fund manager who writes at the Behavioral Macro Blog, diagnoses investors with a bad case of disaster myopia.
"If you went through an earthquake, or were mugged, or whatever traumatic event it might be, you overestimate the probability of that event occurring again," Dow said. "It's because we just went through a bubble that everyone's looking for them. Generals always fight the last war, and firemen fight the last fire." Dow similarly believes that the tremendous deal of concern about a bubble will "probably prevent it," at least for a little while.
"It's never obvious, by definition, or you wouldn't get the bubble," he said.
At that point we really had to laugh out loud. There is no bubble because people search for the term on Google? Their act of searching for the term will 'prevent a bubble' from forming? Really? No-one seems to have noticed that the 'record high in bubble searches in November 2007 in the US' definitely did not indicate that one shouldn't be concerned.
Before we look at some empirical evidence that immediately blows these notions out of the water, let us briefly look at the basis of such claims. The idea that a bubble is never obvious is obviously wrong, because as a matter of fact, all bubbles are obvious to varying degrees to a great many people. Participants are just never sure how big they will become and all of them are hoping that they will correctly guess when the moment to jump off has arrived. In fact, this article itself - which denies the existence of a bubble - is a perfect example of the rationalizations people use to talk themselves into remaining enmeshed and invested in the bubble. Note that no-one mentions valuations, monetary policy, or any of the other yardsticks or forces that may be relevant. Instead, the argument is solely based on search trends on Google!
We already briefly discussed behaviorism in a critical appraisement of Robert Shiller's article on economic science (see: Economics Is a Science). It is of course true that quite a bit of the decision making on the part of investors and speculators becomes increasingly irrational as an asset bubble progresses. The rationalizations tend to become ever more absurd once it becomes difficult to come up with tenable, rational arguments for remaining invested. It is definitely worth studying these phenomena and being aware of them as an investor.
However, what we must also ask is: are there fundamental economic causes for the formation of bubbles? The Mises Institute recently published an article by Frank Shostak that also takes a critical look at Robert Shiller's theories (we encourage readers to read Mr. Shostak's article in its entirety. Similar to the point we made in our article, he argues that behaviorism is definitely not economics. It belongs to the realm of psychology). A few excerpts:
"[...] at the World Economic Forum in Davos, Switzerland on January 27, 2010, Nobel Laureate in Economics Robert Shiller argued that bubbles could be diagnosed using the same methodology psychologists use to diagnose mental illness. Shiller is of the view that a bubble is a form of psychological malfunction. Hence, the solution could be to prepare a checklist similar to what psychologists do to determine if someone is suffering from, say, depression.
1. Sharp increase in the price of an asset.
2. Great public excitement about these price increases.
3. An accompanying media frenzy.
4. Stories of people earning a lot of money, causing envy among people who aren't.
5. Growing interest in the asset class among the general public.
6. New era "theories" to justify unprecedented price increases.
7. A decline in lending standards.
What Shiller outlines here are various factors that he holds are observed during the formation of bubbles. To describe a thing is, however, not always sufficient to understand the key causes that caused its emergence. In order to understand the causes one needs to establish a proper definition of the object in question. The purpose of a definition is to present the essence, the distinguishing characteristic of the object we are trying to identify. On this, the seven points outlined by Shiller tell us nothing about the origins of a typical bubble. All that these points do is to provide a possible description of a bubble. To describe an event, however, is not the same thing as to explain it."
This is a key point. Bubbles don't just drop out of the sky because a critical mass of people begins to display symptoms of a kind of mental illness. There is a causative force at work, something that actually enables bubble formation. So what actuates financial asset bubbles? For asset prices to rise sharply, there is a sine qua non, and that is an expansion of the money supply.
As Shostak points out, an expanding money supply diverts resources from wealth-generating activities to activities that end up consuming wealth, as it enables exchanges of nothing (money from thin air) for something (real resources). Monetary pumping by the central bank and credit expansion by fractionally reserved commercial banks are therefore at the root of bubbles from an economic standpoint.
We recently showed this chart of the broad US money supply TMS-2. Take a close look at the period from 2008 to today specifically. We would argue this is prima facie evidence that a bubble is indeed underway.
The History of Google Searches on Bubbles
When reading the CNBC article discussed above, we dimly remembered that Robert Prechter once mentioned that (paraphrasing) "as a bubble matures, there is increasing evidence of bubble talk".
This is actually to be expected, as asset bubbles tend to exhibit certain repetitive patterns. As they move toward their final stage, corrections as a rule become ever smaller, and the ascent of prices steepens (see this discussion of the 'Sornette bubble model' by John Hussman). In short, it becomes obvious that something unusual is going on. Those who argue that prices cannot be justified by the fundamental data tend to become more vocal as prices continue to rise above what they regard as fair value and public debate intensifies.
In order to find out if there is any correlation between price peaks and Google searches for the term 'bubble' in the context of specific assets, we decided to take a look for ourselves. The results are surprising.
It seems that peaks in bubble searches slightly precede peaks in the prices of the assets concerned. In other words, a strong surge in bubble searches is definitely not a reason to be complacent. On the contrary, it is a warning sign that a major price peak could be imminent. In the case of stocks, the correlation between bubble search peaks and price peaks is a bit less precise than in the other assets we have looked at, but it is still noteworthy.
Below are several charts illustrating the situation:
Google searches for 'oil bubble' rose strongly as oil approached its 2008 top and peaked exactly one month before the oil price did.
Click to enlargeSearches for 'stock market bubble' peaked in May of 2007. The S&P 500 made an initial peak in July, then rose one more time to a slightly higher high in October. Currently searches for 'stock market bubble' are in a strong uptrend, but still remain below previous highs. As this chart shows, the rise into search peaks often happens in a very short period of time, so this bear's watching.
It definitely cannot hurt to be aware of market psychology and sentiment. However, the argument that a surge in searches for the term 'bubble' on Google can be interpreted as an all clear for a bubble's continuation seems to have things exactly the wrong way around. Moreover, it certainly can neither show that there is no bubble, nor can it prevent one, as the economic cause for bubble conditions is money supply growth. One must therefore consider what is happening in the monetary realm when trying to ascertain whether a bubble exists. The misguided behavior of financial market participants that can be observed during bubbles is merely mirroring the clusters of entrepreneurial error monetary pumping brings about.
Addendum: Retail Euphoria
Incidentally, retail investors have recently become quite euphoric. We have discussed this phenomenon previously, and shown that equity fund flows are usually strongly positively correlated with prices (sell low, buy high is the motto). In the meantime the news has found its way to Bloomberg as well. There is not much that is new here of course, aside from the information on allocation percentages which we found quite interesting:
"Investors are pouring more money into stock mutual funds in the U.S. than they have in 13 years, attracted by a market near record highs and stung by bond losses that would deepen if interest rates keep rising.
Stock funds won $172 billion in the year's first 10 months, the largest amount since they got $272 billion in all of 2000, according to Morningstar Inc. estimates. Even with most of the cash going to international funds, domestic equity deposits are the highest since 2004.
The market run-up has left investors as a group with an unusually high allocation to equities, at 57 percent, said Francis Kinniry, a principal at Valley Forge, Pennsylvania-based Vanguard Group Inc., the world's largest mutual-fund company.
Equity allocations were higher only twice in the past 20 years, Kinniry said: in the late 1990s leading up to the technology stock crash of 2000, and prior to the 2007-2009 global financial crisis. He based his calculations on the total amounts of money in mutual funds and exchange-traded funds across asset classes at U.S. Firms."
We hasten to add that the information on recent fund flows should not be regarded as a market timing aid. As we have often pointed out, such information is best characterized as a heads-up, a sign that one must pay attention to the fact that risk is on the rise.