Crash Course Chapter 17: Bubbles

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Transcript

OK now that we’ve taken a look at US assets, we need to spend some time understanding what an asset ‘bubble’ is, how to recognize when one is forming, and the consequences of the aftermath once it bursts. 

And we are specifically going to examine the housing bubble that popped in 2007 in detail, because up to that point it was the largest bubble in recent history to burst, and it's still fresh on people's minds..

Through the long sweep of history, the bursting of asset bubbles has nearly always been traumatic.  Social, political and economic upheavals have a bad habit of following asset bubbles, while wealth destruction is a guaranteed feature.

Bubbles only used to happen once every generation or longer, because it took substantial time for the victims to forget the pain of the damage. 

But that’s changed in the new millennium. Less than ten years after the bursting of the dot-com bubble we saw the bursting of the housing bubble.  This is simply astounding and thoroughly unprecedented. 

More astonishingly, there are now concurrent equity and bond bubbles raging across the entire financial market structure of the world. 

We are in our third bubble period in less than 15 years. This new era of serial bubble-blowing signifies that we are now in new turbulent territory with which we have little historical guidance to draw on.

So how would we know that we’re in an ‘asset bubble’?   What do they look like and what can we expect when one bursts?

The Fed has famously claimed that you can’t spot a bubble until it bursts.  This is flat wrong, and irresponsible to say the least.

Actually, you can and the definition is pretty simple; “A bubble exists when asset price inflation rises beyond what incomes can sustain”.  A bubble represents people abandoning reason and prudence as greed takes over.

Let’s look at one of the more interesting bubbles that occurred in Holland in the 1600’s.  The people of that time famously became infatuated with tulips saw them as a sure-fire path to riches and a financial mania set in.  Yes, we’re talking about the flowers that come from bulbs. 

The bubble in tulip prices began when beautiful and unique variants in coloration were developed and bulbs began trading at higher and higher amounts as the speculative frenzy built.

At the height of the bubble, a single bulb of the most highly sought after example, the Semper Augustus seen here, commanded the same selling price as the finest house on the finest canal. 

Imagine trading a flower bulb today for a premier flat on Park Ave and you've got the idea.

But, eventually people figured out that you actually could grow quite a few tulips if you set your mind to it, and that perhaps bulbs were, after all,  just flowers. 

The record shows that the tulip craze ended even more suddenly than it began, collapsing almost in a single day at the start of the new selling season in February of 1637.  

On that day, a silent whistle blew that apparently only dogs and buyers could hear, and prices immediately crashed. 

This example illustrates two fundamental characteristics of bubbles. First that they are self-reinforcing on the way up, meaning that higher prices become the justification for even higher prices. And second, that once the illusion is lifted, everyone suddenly wants to sell at the same time. 

A second example of a bubble comes from the 1700’s and goes by the name The South Sea Bubble. The South Sea Company was an English company which was granted a monopoly to trade with South America under a treaty with Spain.

The fact that the company was rather ordinary in its profits prior to the government monopoly did not deter people from speculating wildly about its potential future value.

So the share price rose dramatically. Nor were investors concerned by the fact that the company was actually billed by its owners as  “A company for carrying out an undertaking of great advantage, but nobody to know what it is"

Sir Isaac Newton, when asked about the continually rising stock price of the south sea company, said that he ‘could not calculate the madness of people’.   

He may have been the genius who invented calculus and described universal gravitation, but he also managed to end up losing over 20,000 pounds to the bursting bubble; proving that intelligence is often no match for a public delusion. 

In 1720 the South Sea mania took off displaying a textbook perfect example of an asset bubble.  Here we see reflected two additional essential features of bubbles: they are roughly symmetrical in both time and price.

That is, however long it took to create the bubble is roughly the amount of time it will take to unwind the bubble, although they tend to deflate a bit faster than they formed, and prices usually get fully retraced, if not a bit more.    

Here we can see those features in perfect form.  Keep an eye on this shape; we’ll be seeing it again, and again and again. 

And here is a chart of the Dow Jones.  Beginning in 1921 we can see that the stock bubble that preceded the great depression followed the same rough trajectory, requiring about as much time to deflate as it did to inflate and that prices roughly returned to the levels from which they started. 

Of course, we were on a gold and silver standard back then, so that helps explain why price levels returned to their starting point.

And here’s the stock price of GM in the blue line between the years 1912 and 1922 and Intel in the red line between 1992 and 2002; periods during which both stocks were swept up in bubbles. 

Here we might also note that the price data looks very similar for both stocks despite the fact that they reflect a nascent car company and a mature high tech chip manufacturer separated by a span of 80 years.

The fact that bubbles display the same price behaviors over the centuries and decades tells us that they are not artifacts of particular financial systems or periods in history, but rather are shaped by the human emotions of greed, fear and hope. 

Those have not changed through the years and this is why you should hold onto your wallet any time you hear the words ‘this time it’s different’. 

Somewhere along the way people started to believe this about houses.  It got to the point that people began to really believe that a house was a path to riches. 

And even better, it was a magical path that would transport you to easy street even if you sat on your sofa the whole time drinking beverages.

Now, there’s simply no way for this to be true and we should have known better. But by their nature, bubbles succeed in pulling the wool over the eyes of the masses. 

The historical data shows us that – bubbles aside -- over the long haul, house prices will be set by whatever it costs to build a new house meaning that inflation will dictate house prices. 

This amazing chart of inflation-adjusted house prices, created by Robert Shiller, reveals that between 1890 and 1998 house prices tracked the rate of inflation very closely.

In this, any time the chart line is rising, houses are appreciating in price faster than the rate of inflation; and any time the line is falling they are losing ground compared to inflation. 

Over this entire 118 year period house prices averaged 101.2 meaning that inflation-adjusted house prices are roughly comparable across this entire sweep of history.  Real estate prices were stable compared to inflation, then fell before and during the Great Depression, stabilized again, and then rose dramatically after the war.   

See this little bump right here?  That was a property bubble that I still remember clearly because it impacted the northeast where I lived at the time and I got to ride my bike though abandoned construction projects in the years afterward. 

Notice that this property bubble returned to baseline in a fairly symmetrical fashion as did the  property bubble of 1989.

Well, if those were property bubbles, then what’s this?  This housing bubble that had no historical precedent in the US and was massively out of proportion to anything we had ever experienced before. 

There was nothing even remotely close to it in magnitude, leaving us without any history to guide us as to what the impacts were likely to be. 

And also note that this bubble did not suddenly begin in 2004. It began in 1998 and had eclipsed the previous two housing price peaks by the year 2000. 

You might ask yourself “if the Federal Reserve had access to this data, and knew we had a property bubble on our hands as early as 2000, why did they continue to aggressively lower interest rates to 1% and hold them there for a year between 2003 and 2004?”

That’s a darn good question. Because other people, myself included, were actively sounding the alarm.

Now, the original Crash Course was put out back in 2008. In the years before its publication -- in 2005, 6 and 7 -- I was openly warning about what, to me, was an obvious housing bubble. 

Here's what I said in 2008:

Based on this chart, where and when might we predict this bubble to finally bottom out?  Well, symmetry suggests   the bottom will be somewhere around 2015 while history suggest that prices will decline by roughly 50% in real terms. 

How's that observation turning out?  Well, it was almost spot on, though the 44% retrace we experienced happened by 2012, not 2015. So it contracted even more viciously than I had feared.

In fact, I expect that there's more pain to come in this story. The recent uptick in house prices since 2012 is bringing housing prices unsustainably high again in a growing number of markets.

These rising prices mainly reflect the dangerous reflationary policy of the Fed, which is costing about $1 trillion freshly printed dollars each year to sustain.

So perhaps the full 50% retrace will happen by 2015, right on schedule.

So again, where was the Fed during the blowing of the housing bubble?  They were busy writing “research” papers convincing themselves that there was no bubble to worry about, as seen in this 2004 Fed study entitled “Are Home Prices the Next Bubble?”

The main summary of the study started off on a good note stating:  “Home prices have been rising strongly since the mid-1990s, prompting concerns that a bubble exists in this asset class and that home prices are vulnerable to a collapse that could harm the U.S. economy”.

But then main conclusion of the paper veered sharply off into a ditch reading:

“A close analysis of the U.S. housing market in recent years, however, finds little basis for such concerns. The marked upturn in home prices is largely attributable to strong market fundamentals: Home prices have essentially moved in line with increases in family income and declines in nominal mortgage interest rates.”

“Essentially moved in line with increases in family income?” What? One of the most widely known facts of our time is that family incomes did not move up at all on an inflation-adjusted basis during the housing boom and is one of the principal economic failures of the first decade of the millennium. 

This just goes to show that the Federal Reserve is either stocked with inept or biased researchers. And, of the two options, I am not sure which makes me feel worse about our chances of safely navigating through this mess.

But the Fed’s researchers were simply doing what millions of people were also doing at the time; namely falling prey to believing that somehow  “this time is different”. 

But that’s just how bubbles are.  People take leave of their senses, use all manner of rationales to justify their positions but then, suddenly, one day, the illusion lifts and what seemed to be unassailably true no longer makes any sense at all. 

Once that day happens, the fate of the bubble is reduced to measuring the speed of its collapse.

While it’s tempting to feel a sense of outrage over the excesses that created the housing bubble, it’s important to remember that the dramatic rise in house prices was itself just a symptom of a larger credit bubble run amok.

Total credit at the end of 2000, when the tech stock bubble was bursting, stood at $27 trillion dollars.  By the end of 2008 it stood at an astounding $52 trillion dollars. 

This $25 trillion increase in borrowing was 5 times larger than the increase in US GDP over the same period of time.  Any attempt to understand the housing bubble has to be viewed against the backdrop of this massive increase in debt.  

But as we noted in an earlier chapter, this credit bubble has been going on for three decades. Unwinding a multi-generational debt-binge is going to require some enormous changes in attitudes and habits, and quite a bit of austerity.

And that's if we do it on our own terms.  If we don’t facing up to what we’re doing and change our behavior, the adjustment will happen via market forces -- financial accidents and massive losses in stocks and bonds that will wipe out the excessive claims on the markets’ own terms.

As of this writing at the beginning of 2014, the stock and bond market are both at their most expensive levels ever, or very, very close to them.  

Recall, bubbles exist when asset prices rise beyond what incomes can sustain.  Collectively, the facts of having the most debt ever on record, the priciest bonds on record, and the US and several European stock markets at all time highs are a bet that the future will be much larger than the present.

After all, it will be future income that will either sustain the very high asset prices or pay back the principal and interest components.

And it's worth repeating that the prices of various assets such as stocks and bonds have been climbing much faster than underlying organic economic growth.

That is, the debt is climbing faster than incomes AND that debt is now priced at its all time highs.  And not all of it is “good” debt, either. There is now more junk debt circulating than ever, too.

So just as certain as I was that there was a very obvious housing bubble before that reality became obvious to everyone, I think history is repeating itself -- the signs are all there to indicate that we're in the midst of another set of gigantic bubbles in the financial markets, only these are larger, and more global than any before.

One important reason that any bubble is so destructive is because so many bad investments are made along the way as it grows.

Too many houses are built, too many poor loans are made to individuals and companies with poor prospects for paying them back, and too much money is placed into stocks with absurd and astonishingly high price to earnings ratios.

Sorry to say, but all those trillions of dollars of mal-investments are simply wasted – those dollars are gone.  And, worse, their wastage steals opportunities from the things that needed that money more.

The Austrian school of economics has a very crisp and historically accurate definition of how a credit bubble ends. According to Ludwig Von Mises:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion.

The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

This is a view I happen to ascribe to and explains my strong preference for placing my wealth out of the path of a potential financial accident or currency collapse. 

As a nation, we’ve undertaken desperate measures to avoid abandoning the continuation of our credit expansion – a delusionary course that leaves a final catastrophe of the currency as our most likely outcome. 

As for the timing?  It could hardly be worse.  Dealing with a set of nested bubbles is hardly the sort of challenge we need at this particular moment in history, but, here we are. 

The stewardship and vision displayed by the Federal Reserve and Washington DC in bringing this all about has been breathtakingly shortsighted. 

So, what can we expect from a collapsing credit bubble?  Simply put, everything that fed upon and grew as a consequence of too much easy credit will collapse.  I am especially leery of   financial stocks, low-grade bonds and of course, real estate. 

There are entirely too many financial institutions and financialized companies to exist together in a future without rapid credit growth. So we would expect the number of those firms to be drastically cut back to a more appropriate size at some point in the future. 

I see very few conventional ways to protect ones wealth and so I invite you to begin asking yourself and, if you have one, your financial advisor some very hard questions about the safety of your holdings.  You’ll be glad you did.

Remember, this time is very likely NOT different.

The recent years of money printing by the Fed has NOT ushered in a “permanent plateau of prosperity”. And, as with all bubbles, symmetry indicates the downslope after the bursting will be steep, swift and likely quite scary.

Please join us for the next chapter where we explore the extent to which we have been telling ourselves pleasant half-truths and other falsehoods which I call: “Fuzzy Numbers”.

Thank you for listening.

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davide.cristanelli's picture
davide.cristanelli
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Italian translation

I have made the italian translation of the first 14 chapters of the Crash Course. If you are interested you can find it at the following link:

https://www.dropbox.com/l/C9UOYqJpN66BGfchdHkFpq

In the same place I have uploaded the video of some chapter with italian soudtrack.

I will insert others chapters when completed wink.

I hope this will contribute to spread and support the Crash Course in Italy. Thank You for your work!

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