econscius

Irrational Exuberance about Spotting Bubbles

In Economy, Financial Crisis, Real Estate Bubbles on November 29, 2011 at 1:01 am

An excellent and brief article well worth reading is: “The Extraordinary Popular Delusion of Bubble Spotting” by Jason Zweig in the Wall Street Journal.

It is sobering reading for anyone who believes financial crises will not occur as long as wise government regulators are emboldened to pop bubbles.  The most obvious flaw to the bubble popping dream is bubbles are only obvious in retrospect.  How many identified the dot-com mania of the 1990s?  The real estate bubble of the 2000’s?  A handful of commentators and academics identified one or the other; the economist Robert J. Schiller actually identified both bubbles.

Mr. Sweig’s article, found here at http://online.wsj.com/article/SB10001424052970204621904577017960729384948.html, cites recent research from Andrew Odlyzko, who looked at the huge railroad stock bubble that burst from 1845-1850.  Railway stocks declined by 2/3, a drop of $1 trillion in today’s money.   Mr. Odlyzko noted the famous Scottish journalist, Charles Mackay, in 1841 had published the book known today as “Extraordinary Popular Delusions and the Madness of Crowds”.  It turns out the apparent bubble expert turned shill just a few years later.  In 1845, Mackay wrote, “those who sound the alarm of an approaching railway crisis have somewhat exaggerated the danger….There is no reason whatever to fear” a crash.

 

Another issue I see in the case for bubble popping is that regulators are humanThe politicians who oversee regulators are even more human in the sense they are reelected by keeping the public happy.  How many politicians ever push the Federal Reserve to raise interest rates to cut off a speculative bubble?  I am not so optimistic regulators pushing back on Fannie Mae and Lehman Brothers in the 2000’s for subprime lending would have been welcomed by very many. 

When a bubble inflates, it makes money for a lot of people.  In the 2000’s real estate bubble, the list of winners included appraisers, Realtors, mortgage brokers, mortgage lenders, title insurers, professional real estate flippers, home improvement chains, remodeling contractors, furniture stores, homebuilders and all the companies that supplied them, as well as millions of voters who sold their homes for a quick profit or stayed put and watched their home equity rise.  Many of those homeowners took out home equity loans or enjoyed “cash out” refinancing, which allowed them to take a vacation, buy a plasma TV or build a swimming pool using paper profits on their home.  How many politicians, even if they really saw a bubble, were willing to stand up to all those interest groups and essentially tell the average voter “your house is worth less than you think, it is time to pop the bubble by making it harder to sell your house through tougher mortgage standards and higher interest rates courtesy of the Federal Reserve”?

I ask of anyone who is highly confident in the government’s ability to identify stock market bubbles, is there a bubble today?  If so, where?  In tech stocks like Groupon and, speaking of real estate, Zillow.com?  In gold?  In solar firms and electric cars?  My guess is a bubble may now exist in US Treasury bonds, which pay virtually no interest at all, despite the possibility of future inflation.  If there is a bubble, say in social media companies, how should the government go about deflating the bubble? 

Bubbles happen on a recurring basis.  There usually is an exciting new technology (e.g. railroads, rubber, automobiles, plastics, uranium, oil, 1980s farm land, the internet, fiber optic cable) that truly is changing the economy, enjoying explosive revenue growth.  There typically is at least a kernel of truth in the bubble boosters’ claims. 

Valuable Real Estate: London, UK. Photo by author.

In the recent real estate bubble we heard “they ain’t making more land,” population was growing and interest rates were at historic lows, meaning monthly mortgage payments were easy to afford and higher leverage looked rational.  As always happens with bubbles, a feedback loop grows.  People are making money flipping stocks, flipping houses, flipping tulip bulbs.  Friends and family see the easy profits happening and they get it on the game, meaning even more speculative demand, leading to ever higher prices.  Access to low-interest rate credit only adds more air to the speculative bubble.   Valuation becomes unimportant.  To top the valuation problem off, the very fact that the bubble asset is increasing in value reinforces the rising values.  This happened in the 2000s as rising real estate prices meant appraisals kept rising with the ever higher prices of nearby homes.  As long as you value an asset by what it can fetch in today’s market, you are at risk of participating in a bubble.  A safer method of valuation is a fundamental valuation based on discounted cash flow or at least a ratio (e.g. Price/Earnings or “P/E” ratio) which ties the asset back to its income earning potential.

Some bubbles aren’t large enough to matter to the overall economy.  Some deflate without causing an economic crisis.  Other bubbles burst and bring great short-term damage to an economy and society.  Given that bubbles can be so dangerous, it is only natural to want to embolden some wise power to deflate them.  

Granting someone bubble popping power also creates the possibility of a false positive: trying to deflate a “bubble” which may not actually be a bubble.  We have heard for decades the real estate in certain high-priced markets like Manhattan, San Francisco and London is fundamentally overpriced.  But is it?  Perhaps the higher wage earning potential and high demand for property in those land-constrained cities does justify the real estate premium vs. smaller cities elsewhere.  Some internet stocks were a bubble, yet others like Google and Amazon once seemed overpriced to many, only to prove the doubters wrong.  That is, unless those stocks were to crash tomorrow because of some previously unidentified flaw in their business model and disprove the statement I just made.

The problem is who, exactly, can identify a bubble and then prick the bubble, even when it makes voters angry?  What bubble(s) is inflating right now?  One way we can individually fight the next bubble is to keep our heads about investing.  If all our non-expert friends and relatives are bragging at dinner parties about their investment in the “Next Big Thing” because it keeps going up in value, then maybe we should research and understand that Big Thing before we bet our life savings on it.  Unless, of course, it is 1984 and your friend is talking about some new company named Microsoft. 

Bubbles and Charles Mackay pictures from Wikipedia Commons.

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