You can almost feel it in the air. The froth and foam on markets of all shapes and sizes all over the world.
There’s nothing like a rising market to lift our mood. But what if the rising market is … a bubble?
Are we smart enough to ride it high and then bail out before it bursts? Research says we all think that we are, yet we rarely demonstrate the actual ability. So, this week we’ll think about bubbles.
One area that stands out as particularly bubbly is the corporate bond market.
Investors are barely being compensated for the risks they’re taking. In 2007, a three-month certificate of deposit yielded more than junk bonds do today.
Average yields on investment-grade debt worldwide dropped to a record low 2.45 percent as we write this from 3.4 percent a year ago, according to Bank of America Merrill Lynch’s Global Corporate Index.
Veteran investors in high-yield bonds and bank debt see a bubble forming. Wilbur L. Ross Jr., chairman and chief executive of WL Ross & Co. has pointed to a “ticking time bomb” in the debt markets.
Ross noted that one-third of first-time issuers had CCC or lower credit ratings and in the past year more than 60 percent of the high-yield bonds were refinancings.
None of the capital was to be used for expansion or working capital, just refinancing balance sheets. Some people think it is good there is no new leveraging, but it is much worse. This means many companies had no cash on hand to pay off old debt and had to refinance.
One day, all the debt will come due, and it will end with a bang.
“We are building a bigger time bomb” with US$500 billion a year in debt coming due between 2018 and 2020, at a point in time when the bonds might not be able to be refinanced as easily as they are today, Ross said.
Government bonds are not even safe because if they revert to the average yield seen between 2000 and 2010, 10-year treasuries would be down 23 percent.
“If there is so much downside risk in normal treasuries,” riskier high yield is even more mispriced, Ross said. “We may look back and say the real bubble is debt.”
Another bubble that is forming and will pop is agricultural land in many places in the United States. The bubble really started going once the Fed started its Code Red policies.
Land prices in the heart of the Corn Belt have increased at a double-digit rate in six of the past seven years. According to Federal Reserve studies, farmland prices were up 15 percent last year in the most productive part of the Corn Belt, and 26 percent in the western Corn Belt and high plains. Iowa land selling for US$2,275 per acre a decade ago is now at US$8,700 per acre.
The increase in farmland prices beats almost anything the United States saw during the housing bubble. A lot of banks in the Midwest will have problem with their lending.
Why are we seeing so many bubbles right now? One reason is that the economy is weak and inflation is low. The growth in the money supply doesn’t go to driving up prices for goods like toothpaste, haircuts, or cars. It goes to drive up prices of real estate, bonds, and stocks.
Excess liquidity is money created beyond what the real economy needs. In technical terms, Marshallian K is the difference between growth in the money supply and nominal GDP.
The measure is the surplus of money that is not absorbed by the real economy. The term is named after the great English economist Alfred Marshall. When the money supply is growing faster than nominal GDP, then excess liquidity tends to flow to financial assets.
However, if the money supply is growing more slowly than nominal GDP, then the real economy absorbs more available liquidity. That’s one reason stocks go up so much when the economy is weak but the money supply is rising.
Economists and investors have spilled a lot of ink describing bubbles, yet central bankers and investors never seem to learn and people get caught up in them.
Peter Bernstein in Against the Gods states that the evidence “reveals repeated patterns of irrationality, inconsistency and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty”.
Bubbles happen again and again. The same basic ingredients are found every time: fueled initially by well-founded economic fundamentals, investors develop a self-fulfilling optimism by herding that leads to an unsustainable accelerating increase in prices.
And each time, people are surprised that a bubble has happened. As billionaire investor George Soros once said about financial cycles: “The only surprise is that we are always surprised.”
The conclusion from repeated experiments shows that it doesn’t matter if people live through one bubble or even two, they’ll likely fall for bubbles again.
The smarter people learn from bubbles. But they don’t learn to avoid them; they participate again and simply think they’re smart enough to know when to get out.
This has been shown many times in trading experiments conducted by Vernon Smith, a professor at George Mason University who shared in the 2002 Nobel Prize in Economics.
As Smith said: “The subjects are very optimistic that they’ll be able to smell the turning point. They always report that they’re surprised by how quickly it turns and how hard it is to get out at anything like a favorable price.”
There is no standard definition of a bubble, but all bubbles look alike because they all go through similar phases. The bible on bubbles is Manias, Panics and Crashes by Charles Kindleberger.
In the book, Kindleberger outlined the five phases of a bubble.
Stage 1: Displacement
All bubbles start with some basis in reality. Often, it is a new disruptive technology that gets everyone excited, although Kindleberger says it doesn’t need to involve technological progress.
It could come through a fundamental change in an economy; for example, the opening up of Russia in the 1990s led to the 1998 bubble or in the 2000s interest rates were low and mortgage lenders were able to fund themselves cheaply.
In this displacement phase, smart investors notice the changes that are happening and start investing in the industry or country.
Stage 2: Boom
Once a bubble starts, a convincing narrative gains traction and the narrative becomes self-reinforcing.
As George Soros observed, fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values.
For example, in the 1920s people believed that technology like refrigerators, cars, planes and the radio would change the world (and they did!). In the 1990s, it was the internet. One of the keys to any bubble is usually loose credit and lending.
To finance all the new consumer goods, in the 1920s installment lending was widely adopted, allowing people to buy more than they would have previously.
In the 1990s, internet companies resorted to vendor financing with cheap money that financial markets were throwing at internet companies. In the housing boom in the 2000s, rising house prices and looser credit allowed more and more people access to credit.
And a new financial innovation called securitization developed in the 1990s as a good way to allocate risk and share good returns was perversely twisted into making subprime mortgages acceptable as safe AAA investments.
Stage 3: Euphoria
In the euphoria phase, everyone becomes aware that they can make money by buying stocks in a certain industry or buying houses in certain places.
The early investors have made a lot of money, and, in the words of Kindleberger, “there is nothing so disturbing to one’s well-being and judgment as to see a friend get rich”.
Even people who had been on the sidelines start speculating.
Stage 4: Crisis
In the crisis phase, the insiders originally involved start to sell. In the subprime bubble, chief executives of homebuilding companies, executives of mortgage lenders like Angelo Mozillo, and chiefs of Lehman Brothers like Dick Fuld dumped hundreds of millions of dollars of stock.
The selling starts to gain momentum, as speculators realize that they need to sell, too. However, once prices start to fall, the stocks or house prices start to crash. The only way to sell is to offer prices at a much lower level. The bubble bursts, and euphoric buying is replaced by panic selling.
Stage 5: Revulsion
Just as prices became wildly out of line during the early stages of a bubble, in the final stage of revulsion, prices overshoot their fundamental values. Where the press used to write only positive stories about the bubble, suddenly journalists uncover fraud, embezzlement, and abuse.
As investors stay away from the bubble, prices can fall to irrationally low levels.
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