A Note to the Bubble-Phobes

Robert Shiller writes in Sunday’s New York Times about the collective failure to see the housing bubble. Obviously, some folks will insist that they saw everything coming, and it was perfectly predictable.

One of the problems I have with this idea, and I’ve mention this before with Shiller’s other work, is the curious idea that a bubble is somehow a problem that needs to be fixed.

Just because prices go up very rapidly doesn’t mean something is a bubble. Oddly, the only time we can be certain that it’s a bubble is when the air deflates and the asset prices go down. In other words, to the bubble-phobes, the problem isn’t the bubble, it’s the downside, and we only know what after the fact.

How can we be sure it’s a bubble when an asset inflates? In the 1950s, stock prices soared and they never really came back down. The phrase “permanently high plateau” hasn’t had a good record since the 1920s, but I think that’s an accurate description of what happened in the 1950s.

Is gold a bubble right now? What about oil? Or the Euro? Or could it be that we’re simply adjusting to a new era of commodity prices? I don’t know and for now, I’m happy to consider these open questions. I will note, however, that adjusted for inflation, commodity prices have historically plunged.

For me, the best definition of a bubble is a price that’s going up because it’s going up. The certainly happened with tech stocks in the 1990s. But I’d rather not have Alan Greenspan tell me what the prices of tech stocks ought to be.

There’s also the counter argument that bubbles aren’t merely not bad, but actively good. In his book, Pop!: Why Bubbles Are Great For The Economy, Daniel Gross writes how bubbles and their ugly aftermath have often helped lay the ground work for future prosperity. A bubble creates enormous excess capacity which can later be used to bring down the cost of applying a new technology.

Shiller writes, “The failure to recognize the housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the United States and around the world.” Actually, the collapsing house of cards is the recognition of the bubble. After all, the bubble could have gone on for another three years. Perhaps free enterprise spot it early and cut it off. Hooray for markets!

Comments

[daffy]

Eddy,

We have a marginally industrialized nation coming on line. A big one. That's called China. Are commodities going to hit a permanent plateau? I would say so with the exception of a few items. You also have to remember, that as a blossoming nation, China will have excesses and wastes. The nation will therefore consume much more than it needs and at some point efficiency will step up to the plate, BUT that didn't stop the fifties here in the US from being a permanent plateau. My bet it will be ten years until everything settles down in China and the rate of consumption levels off. Could be twenty years before any contraction takes place. That will place a huge demand on natural resources throughout the world. I also think that as time progresses, manufacturers in China will also realize that product quality(which is hugely lacking) is an important part of the equation and will ramp that up to absorb much more of the global market, thus increasing their demand for raw materials(which should equal demand reductions from peaking efficiency). I think the commodity prices and the shipping stocks are just getting started. If you really sit down and think about it, I think you will agree. I would bet that China has not even come close to saturating itself and India, leaving quite the auditorium for growth. Of course this is no real news, I think it is just very underestimated as to what China's demands are going to be in the future.

As for the housing bubble? Permanent growth like we saw in the early part of this decade is not possible. The market had to correct and adjust itself. I personally think the market has over-reacted and will level off at manageable levels within three years, at a higher per-dwelling value than now. The ocsillation in the market here did not have to be such a tragic one, but such is the human condition, wrought with fear.

I have no clue what my home value is today, nor do I care since I will not be selling anytime soon, even if I vacate. That would be downright foolish. I bought my home fresh out of college, with a lower than average credit score, with a 100% financing in 2004. You try and do that now. I am very greatful for all of the opportunities I had. My home value may be depreciating, but it will return. Overall, I am very happy to have a home and I will second your Hooray for the market only in that I was afforded great opportunities that I would not have today. I just hope your next Hooray will be for the market when it actually reaches equilibrium and the fear has been wrought from the market. As callous as I think it is to Hooray the downturn in anyone's life (especially those who are getting busted in the ARM joke), I do agree with your point.

I think what the market needs today is an article titled: "Facilitating long term recovery from market over-corrections"... Gee, it would be nice to see something positive come out of the last 6 months.

[Cobblestone]

Isn't there a "bubble" when price is extra-ordinarily out of line with a particular variable and is caused by "artificial" and temporary factors (i.e. homes prices, wages & "easy" financing)?

[BasicFinance]

I don't think it is as hard to spot bubbles as you imply it is. I'm not an economist nor am I an active investor, yet I seem to remember a very basic idea in an introductory text on corporate finance: that an asset should be valued as the sum of all expected future cash flows adjusted to net present value. Anyone who looked at what the implied rent would need to be to justify house prices two years ago would have concluded that houses were overpriced. Same with the tech bubble. If you thought about what magnatude of future profits would be needed to support the valuation of the stock market, you would have known there was a problem.

[Malkiel]

I agree with JMC and Basic Finance, bubbles are more than just a robust price trend. The housing "bubble" was brought on by large-scale granting of loans beyond the normal range of affordability based on the borrower's income, the factor which is now correcting itself. I don't see anything abnormal or unsound about the pricing of foreign assets or commodities that justifies the "bubble" moniker, but I do agree with the basic premise that a "bubble" is an opportunity for wealth, as is any upward imbalance in the normal expected profit from a given investment. Of course, the return to the mean sheds wealth for many as well, but we seem not to focus so much on that side...

[jcrash]

Well, by your definition, we have an inverse bubble now. Prices are going down because prices are going down. In stocks and in housing (not in my area, but in the Case-Schiller's 20 preselected bubble areas).

The dude wrote a BOOK about market armageddon, all he will ever espouse will thus be negativity.

There are some SUPER duper bargains in tech stocks right now. Honestly, the rest of the market is probably overvalued - ag definitely, mining absolutely, oil stocks - yep, but tech is trading at P/Es of 12-18 in most cases with growth driven by markets that actually grow instead of very flexible markets which are already reacting to speculator driven commodity bubbles.

Buy tech, forget the rest.

[Fed up]

I couldn't agree more with the previous posters that many bubbles are not that hard to spot well before they burst. The S&L fueled real estate crisis, the stock market bubble of the 90's, and the recent housing bubble were all quite obvious. When a market by all reasonable measures is way overpriced, every Tom, Dick and Harry is jumping on board, and the market is as corrupt as your local drug dealer, you might have a bubble. Duh. The only surprising thing is that our esteemed leaders don't take action to even address the corruption until the damn bubble pops. Don't any of them have the gumption to take away the punch bowl when the party is laying facing down in the gutter? Really now, the corrupton we tolerate in our economic system is appalling and has much to do with the excessive swings from boom to bust.

[eddy]

Thanks for the comments. A number of you pointed out that it isn't that difficult to spot bubbles. I agree with two caveats. One is that you can spot bubbles based on historical comparisons. What if those have changed? The markets dividend yield was often higher than long-term interest rates, now it never is. Going by the old metrics, we've been in a bubble for decades.

That brings me to my second point that even if we're in a bubble, that doesn't mean the bubble won't continue to get worse (or better depending on your point of view). Alan Greenspan's famous "irrational exuberance" comments came years before the market reached its peak. The market may revert to the mean, but it may time a long time getting there. Spotting a bubble is a lot easier than spotting a top.

Thanks again for these very astute comments!

[tradersystemguru]

Couldn't disagree with you more. Bubbles can be readily easily identified on long-term charts (visually), temporary disconnects of long-term historic relationships (like the relationship between rents, incomes and housing prices) or any other metrics simply going seriously out of whack. One only had to look at Shiller's long-term housing chart of inflation-adjusted home prices, building costs, interest rates and population to see that prices were seriously out of whack by 2004-05 (see tradesystemguru.com/co... ) Home prices rose 50% above any previous inflation adjusted peak and you didn't have to be psychic to know that it was only a matter of time before prices seriously corrected.

The real challenge is not in recognizing a bubble in the process of forming, but when it will finally pop.

Matt Blackman
TradeSystemGuru.com

[User 160090]

It's a bubble when the cost of financing a newly purchased home is 2x, or more, the cost of renting an equivalent home despite the loosest and cheapest credit in memory.

It's a bubble when the hairdresser on main street is telling you about the condo she bought with her poor credit and no money down negative amortizing loan and her plans to "flip" the house in three months to make more than her annual salary in profit.

It's a bubble when the media begins proclaiming a new financial reality in the sector of the economy that defies a logical explanation.

A monkey could have got a loan to purchase a house during the past several years. Therefore, a monkey should have foreseen a significant bubble in housing and the fact a corretion was inevitable.

[Can'tSpotABubble?]

You can't be serious? Anyone who was paying at least the slightest attention to real estate could have seen that we were headed into a bubble as early as 2002. I echo the sentiments of other posters about our "officials" looking the other way to corrupt practices.

I realized we were in a bubble in 2002, sold my house for the highest price ever in the subdivision, the day it was put on the market. In Missouri no less. They wanted to close so quickly I had to rent what I thought at the time was a short term apartment before buying another house. A month after the close, I visited a mortgage broker buddy who told me I could borrow with little or no documentation, TEN TIMES my annual income.

Thank god I had the sense to walk away and continue renting my "short term" apartment. BTW my apartment is 25% of the cost of "owning" the same space in the same neighborhood even at current prices. That only figures PITI and not other associated costs.

I also am grateful that I had the sense to get out of the market completely (with the exception of some long positions I've had almost 20 years) on the recent run up.

When real estate dips below it's historical norms, as it will since everything overshoots on the downside, I'll be standing there with a pile of cash to buy my next house outright. Meanwhile my landlord can continue to eat negative cash flow and subsidize my domicile.

I imagine the real interesting times will start when AMBAC or MBIA is finally given up for dead. Or perhaps when one of the larger financial institutions fess up about a 100 billion dollar skeleton in their closet (Citigroup).

In the mean time, get some funds out of dollars (Canadian dollar for me @ .70, a 40%+ profit at todays rate). Get anything else other than your REALLY longs under FDIC cover, buy a bit of gold, and buy staples in bulk as the prices will continue to rise.

I think that double edge sword of a Chinese proverb is coming true....
May you live in interesting times.

Preserve your capital accordingly.

[CommodityBubbleProponent]

I'd be interested to see how much demand there would be for commodity futures if traders were required to post 25-50% of the value of the contract before buying rather than the pitiful 7% that they do now.

Based upon the capital layout to expected cashflow from these "commodity" investments (and I say that b/c these investors don't buy the actual commodity), these futures markets are ripe for speculation. (cough...Amaranth...co... "Runaway" world oil demand has increased at it's height by 2% per year (2001-2003) and is now less than 1%. In any other industry, that type of demand growth would be pathetic.

BUT...I don't think bubbles are a horrific thing. There was a real demand for new housing, and the tech "bubble" produced one of the highest margin industries in the world (typical margins exceed 25% of revenue today), and this commodities bubble will breed and create new business that grow the global economy.