Toiling Over Bubble Troubles
There is a religious war aspect to what I will discuss this evening. It surprises me, but there are many people who believe that bubbles cannot exist, because economic players are rational in aggregate. I question the latter assumption — anyone who follows the equity markets understands the fads that sweep through the markets, leading to a lot of disappointment later.
From one of my comments in the RealMoney Columnist Conversation:
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David Merkel |
| Housing Bubblettes, Redux | ||
| 10/27/2005 4:43 PM EDT |
From my piece, “Real Estate’s Top Looms“:
Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow’s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.
As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
I’m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.
That’s why I think the hot coastal markets are bubblettes. My position hasn’t changed since I wrote my original piece.
Position: none
(If you have a subscription to RealMoney, you should look at the Real Estate piece. It was prescient. I occasionally get things right.)
At present, we are hearing murmurs about a crude oil bubble. Here’s my initial question: Who is borrowing money to buy oil? When we had the housing bubble, we had many investors that had to feed their properties to keep them afloat. They were relying on capital gains to keep themselves solvent. That is always a sign of an overheated market. With the tech bubble, we had vendor financing, and stock options on which people had a hard time affording the taxes. In the commercial real estate bubble 1989-92, rents were not sufficient to cover financing costs.
Think of it this way: at the end of a bubble, someone looks at buying an asset, and concludes that it is not worth buying because of the likely stream of payments he will have to make after the initial purchase.
But what of crude oil? There are a number of noises over short covering in the press. The futures curve looks like a bowl, with the far distant futures higher than spot. Crude oil has had a vicious move upward over the last three months. That doesn’t bother me because vicious moves are common in markets where supply and demand are inelastic in the short run.
But there are speculators. Not your common run-of-the-mill speculators, but ones that dress in fancy suits, and have fancy asset allocation equations. Pension funds, and other long term investors are buying commodities and hoarding them, because they think the commodities will be more valuable in the future. But, they are not borrowing to do it, are they? Er, no, not exactly, but yes, in practice. Every pension plan is borrowing implicitly at the discount rate specified by their actuary. If you don’t earn that rate, you fall behind. For now, ignore the correlation arguments that are meaningless because correlations aren’t stable, and think in absolute terms. Every investment that my pension plan invests in should aim to beat the actuarial funding rate.
Will crude oil appreciate at an 8% rate for the next 10 years? Maybe. Can the pension fund emotionally survive a 40% drawdown? Probably not; most pension trustees are scaredy-cats. They will sell oil during the panic. The consultants, with new statistics, will help them do it.
Now, in the present environment, I think that oil has some bubble in it, but it is not the majority of the recent move. As in the late 70s and early 80s, conservation moves slowly, but it does grind prices down. What is different here is that there are many countries willing to take up the slack near current prices, thank you.
So, I don’t buy the bubble rhetoric for crude oil here. Supply and demand are tight, and over time, high prices will create new technologies that use less fuel. But it will take time. For the next few months, will be volatile, but the one scenario I don’t think will happen is a large fall in the price in the short run.
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Before I leave for the evening, one last comment from the past on bubbles from me:
Rapid money supply growth with no consumer price inflation can only really occur within the confines of an asset price bubble, or else, where does the money go? Interest rates are low at such a time because of the incredible liquidity, and complacency of lenders that they will get an equal amount of purchasing power back. Perhaps another possibility is when a country’s currency is being used more and more as a shadow currency, like the US in the Third World. But even that will come home someday.
May 23rd, 20086:59 am at
I’ve been expressing this opinion for quite some time and largely am in agreement with David. I believe that there is a bubble in the use of the term “bubble”! Based on my examination of history, the common thread through all major bubbles are two fold. First, they are fueled by a reckless growth in credit which fuels the bubble. Second, this mis-allocation of capital is so immense that it has a major economic impact post-bubble for a long time.
I think that people are way to fast to label speculative excess as a “bubble”. Did US equity form a bubble from 1985-1987? I would say no, but given many people’s current criteria it was. Prices ran up in a speculative frenzy and resulted in a crash. However, there was not a credit mania and did not result in a major mis-allocation of capital - that is why the economy remained sound even after the crash.
Personally, I believe that crude will suffer a massive correction or possibly even a crash at some point in the next 6-12 months. However, speculative frenzies can get looney and REALLY go parabolic, so the correction could be from $150 to $100! This action is very typical in the 3rd to 6th inning of a long bull market. Stocks in the US in 1987 and the horrible gold correction that started in 1973 is another. The fact is that there will simply be too many owners of crude at some point and that may create a vacuum to the downside which will cause a deleveraging and panic selling. However, trying to pick a top in such an environment is a dangerous business - I have simply moved out of the way.
May 23rd, 200810:45 am at
Nice article. Have a good Memorial Day.
May 23rd, 200811:05 am at
Bubbles fit the cliche about pornography, no one can define them but supposedly we all know them when we see them. What crap.
People label events as bubbles when they have no explanation or understanding of why something is valued at its current price.
If oil is a bubble now, when did it become one? Why is it a bubble at $130 but not $80, $90, $100, etc.?
If housing was a bubble, at what point did it become one? Housing prices almost always rise. Can anyone who claims housing prices were a bubble identify which year they became bubblicious? Which month then? Falling prices now do not prove there was a prior bubble.
Use of the term is either laziness, or used for alterior motives.
May 23rd, 200812:10 pm at
Excellent piece David! I, like James, think the biggest bubble is in bubble-calling. As I quipped here a few months ago when people were calling a bubble in treasuries: it’s not a bubble until people are buying zero’s above par.
I had a few rules of thumb of my own for distinguishing a bubble from unsustainable speculation, but I think I like yours best as it cuts right to the chase: it’s the financing stupid.
Which reminds me, when I was a kid, across the street from my grandparents house, out in a rural part of the county their neighbor, a realtor, had in his back yard a big hole with a tank in it. He had bought a gas station tank to store gasoline in. Before he could complete the project the bottom had fallen out of oil. I guess you could say he was lucky. He was only in for the cost of a hole and a tank. He never filled the tank, so he didn’t quite buy at the top.
Whether it took financing to buy the tank and dig the hole, probably not. But like pension planners you refer to there are oppr costs nonetheless, and those can be treated like costs of financing all the same.
May 23rd, 200812:41 pm at
Allen,
“it’s the financing stupid.” I think one of the reasons treasuries are a bubble is that the world is over financing the US. The data is undeniable.
shrek
May 23rd, 20082:42 pm at
Bubbles? too much money chasing too few goods & services. What else?
All bubbles are easy to identify. All debits cleared through demand deposits with the exception of Mutual Savings Banks (since their inception).
Monetary flows (MVt)are a mathematical truism. Predictions are infallable.
May 23rd, 20083:38 pm at
I am certainly no bubble expert and I would not argue one way or the other about a bubble in oil currently. To a large degree the argument is an irrelevancy. But a couple of points/questions.
With regard to your first point about oil, lots of people are borrowing money to buy oil. You can buy $133,000+ worth of oil for future delivery with under $9,000 down.
What is your opinion of what is commonly regarded as a bubble in tulip bulbs in Holland in the 17th(?) century? Was that a bubble and if so was it caused by easy financing?
How about internet stocks at the turn of the century? I am not sure I get how that was caused by easy financing. I can certainly see how margin debt helped fuel the bubble, but not how it caused it.
I am not trying to be provocative, I really am curious as to your thoughts. I think financing is a necessary but not sufficient condition for a bubble to form. But I don’t think financing is generally a primary cause of a bubble.
I think the housing situation is actually unique historically. I am not aware of any other situations where you could buy a significant asset or assets with little or nothing down and have a pretty good shot at walking away from your financing obligations if the asset price didn’t appreciate. That was not the case with internet stocks, tulip bulbs, and certainly not with oil today.
May 23rd, 20086:28 pm at
Yes, finacing is necessary, but not sufficient. I don’t know that you could come up with a flow chart for ascertaining when a bubble is about to form. To a certain extent human psychology is involved and that’s hard to quantify and impossible to predict.
David’s point, and one you can actually invest upon, is when the financing goes away, the bubble will pop. In all the cases he cited, the financing went away. It took longer than it should have in every case because the CYA regulators did not want to be blamed for ruining what was generally regarded as fabulous economic growth. But eventually the market demands the financing go away. Colloquially you hear it’s when there is no one left to lend to, that’s the Ponzi nature bubbles. More rigorously it’s when the next round of speculators can no longer service the running interest on their speculation.
In housing we had negative amoritization there at the end to keep the bubble going. It finally popped when early payment defaults (that is loans that never had one payment made on them) started flying back to the originators killing their cash flow and thus their ability to fund a new round of loans. Yeah, it’s all 20/20 in hind-sight.
May 23rd, 20086:38 pm at
Oil will bust when hedgefunds face taking delivery, and there’s no room to store 80,000 barrels of heating oil in the parking lot.
Or maybe more rigorously, when the cost of rolling the contango to next month exceeds the capital gains on last month’s roll.