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:


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.