Saturday, January 06, 2007

Speculative Manias and Bubbles and What's to Come

A market bubble is a uniquely man-made fiasco driven by two of humanity's constant attendants to catastrophe throughout the ages: stupidity and greed.

Speculative markets are belief systems of convenience with six main ingredients:
  1. Extremes of popular, positive investor sentiment–the general belief that the price of a stock, house, or commodity can only go up, such as gold in 1980, tech stocks in 1999, and housing in 2005.
  2. Valid Core Beliefs that are based on fact, such as the value of the Internet during the Internet bubble or of a home to a middle class household, that drive early adopters into the market.
  3. Invalid Apocryphal Beliefs that are later invented by those who are benefiting the most from the bubble, such as investment banks and venture capital firms during the Internet bubble, but readily accepted by everyone else who is also benefiting–notably owners of capital and politicians including government regulators–to explain extreme price increases that go far beyond the level justified by the Core Beliefs.
  4. A well developed system of sales, marketing and distribution, that includes the mainstream press, and employs an army of analysts, consultants, lawyers, accountants, and so on, all of whom adopt first the Core Beliefs and later buy into the Apocryphal Beliefs.
  5. A duration that exceeds the warnings of early bubble spotters by months or years.
  6. A re-distribution of wealth in the usual direction, from suckers to exploiters of the human desire to get rich quick.
Financial manias are millions of people working together to clear-cut a market for short term gain. In spite of warnings, participants persist in a process guaranteed to cause harm to themselves long term because they are making so much damn money right now. But make no mistake, speculative manias are not a zero sum game.

After they inevitably end these manias leave two flavors of damage in their wake, one psychological but very real and the other operational, the result of a political reflex that re-enforces and gives life to negative market psychology. Losses create an indelible connection in the minds of participants and witnesses alike between the present and the future of the market in question. They associate the market where the speculation fun and agony occurred in the past with a certaintly of losing money in the future. The market falls ill from fear, anger, and shame. Politicians, always eager to boost their careers as can-do guys, satisfy the urge of market participants to see that someone is punished for not only the frauds and abuses that attend every mania, but even their own foolishness and greed. This takes the form of regulation that is intended to prevent a repeat sheering of the same sheep by the same sheep husbands. Heavy handed regulation, such as Sarbanes-Oxley, results. Fear of losing money in the market becomes a hard reality.

Think of the market for IPOs of technology companies on the NASDAQ, for example, where requirement for lock-up–the time that must go by between the time a company goes public and the investors get to take off with the moolah–was extended to a full year, well beyond the time when even the most fleeceable believer might overlook all the possible futures for a newly public company with no future. Bye-bye tech IPO market. In the future, expect stringent new rules on dealers in sub-prime loans, and–finally–some enforcement of existing ones. In the collective punishment phase of a post bubble period, regulators tend to go overboard, executing their duties with flourish and drama. The most extreme example followed the collapse of the South Sea bubble in the early 1700's. Subsequently, the issuance of private securities was made illegal for 100 years. After the regulators get hold of it, the market hibernates until the next generation of politicians shows up to "discover" it and its potential anew.

August 2002: Warns of Housing Bubble
Signs of a housing bubble were obvious by August 2002, chief among them prices rising faster than incomes and the insistence of participants that prices only go up. The shocker was the Fed and banking regulators allowing it to go on and on. What could they have done? Enforce the law, for starters. In the past the Fed has been activist in squashing speculation in real estate, and with good reason. In regions of the US where housing speculation boomed in the past, such as Houston in the 1980s, the bust left lasting damage; the housing market, economy, and banking system got hammered. The Fed believes that insurance in the form of credit default derivatives will save the lenders. It's possible, but unlikely. By allowing the housing bubble to grow to absurd proportions, the Fed abdicated its banking system oversight responsibility in favor of its role as steward of the economy. Over the next couple of years they will lose on both counts, as I will explain later.

January 2004: How Housing Bubble will End
Housing bubbles end in a predictable way. The most common criticism I've received recently over this housing bubble end forecast and the two below are that they are "old," by which I assume a fair number of readers like their forecasts delivered after the event versus beforehand.

January 2005: Housing Bubble Correction
Housing bubbles collapse predictably. The timing is hard to get right. Five to seven years corrections are typical for a normal real estate boom-bust cycle. As this speculative bubble was abnormal, reverting to the mean will take longer. I estimate ten to 15 years.

June 2005: Housing Bubble Top
Nothing helps a watcher of man-made market disasters pick out a top like the expression of high spirits by market participants at the zenith of a speculative market. Today I can still see the high water mark on the walls of the main ballroom of the Ritz-Carlton on the top of Nob Hill left there by a party put on by the Red Herring in San Francisco in 1999. Booze parties commonly held at Florida condo sales events marked the top of the real estate bubble.

2007 Forecast.......A housing bubble bust is death by a thousand cuts. Home owners only realize how much poorer they are than they thought they were when they either try to sell or extract equity. They bum out one by one, and the aggregate negative wealth effect therefor tends to lag a whole year behind actual median home price declines.....
"A housing bubble bust is death by a thousand cuts"...excellent!

You can read the rest here.

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