“I have nothing against investment banking, but it’s like massaging money rather than creating money”
Michio Kaku (1947- ) Japanese-America theoretical physicist, futurist and author.
Like in this famous quote by Michio
Kaku, the U.S. real estate
bubble that began to unravel in 2007
was a byproduct of years of
“massaging” a tangible segment of
the economy. All that entangled web of
collateralized mortgage obligations
(CMOs) eventually became part of a massive pyramidal ruse, the aim of which was to seek a
“greater fool” on whom to offload what became a ticking
bomb.
The lubricant came from “rocket scientists” devising complicated mathematical formulas to manage risk through a brilliant but flawed process of “tranching”, and rating agencies that blindly offered their seal of approval on the toxic investments.
Who would have thought that the credit agencies didn’t quite grasp the complexity of these instruments or that they were embroiled in all sorts of conflicts of interest with the very creators of the instruments? The unsuspecting investor didn’t really have any cause for concern. What makes a bubble so incredibly difficult to detect is that we cannot rely on past bubbles to identify new ones.
Every bubble is unique in the process of becoming one. With the internet bubble it was the farfetched notion that the internet had somehow created a “new economy” with vastly differing properties to the existing one. With the "altered" laws of physics, it didn’t matter much that a startup company in the Internet business2 could command stratospheric valuations and have no sales.
So just as with certain diseases, bubbles are notoriously elusive. Because of their very nature, it is usually too late when one realizes that he is in a bubble environment. Still, as with certain diseases, bubbles aren’t totally invisible, they do leave traces along the way.
An example of a detection tool for bubbles are the valuation multiples of stocks. When multiples of a broad index is way above its historical average, this can be suggestive of a bubble formation. Other similar ratios can also be used to provide additional clues.
Another, more subjective technique is to listen to all the chatter around you. The classic example is the cab driver that suddenly boasts about his or her skills in picking stocks and the killings made in the portfolio investments. Yet another example would be the frequency of the word “bubble” being mentioned in media or articles on the subject of bubbles at a given moment in time. Apparently, the more talk about bubbles in the media, the less likely it is that we are in one (so we should be worried when there is scant mention of bubbles).
Finally, there are the multitudes of objective or subjective measures (depending on how you look at it) that one can implement to detect bubbles. A good example would be to take the rolling average price of an investment and set a lagging two standard deviation limit above it. If and when the limit is breached, this could constitute a signal that a bubble may be forming.
All this talk begs the question as to whether the current market environment is one of a bubble or even conducive to its formation. Stock markets in developed economies have achieved record performances over the last year, multiples are significantly above historical averages in the U.S. and recent IPOs and acquisitions are in some ways reminiscent of the dotcom craze period of the late 90’s. To top it all off, corporate debt has soared as businesses tap into the attractively low interest rate environment, and private equity firms have had a record year in terms of cashing in on their investment portfolios.
Still, valuations are not exactly at insane levels (like they were during the dotcom craze), there doesn’t seem to be any particular segment of the economy that is behaving like the sky was the limit (as with the housing craze of the early 2000’s), inflation remains clearly subdued (and even deflationary in Europe) and I, at least, haven’t come across a cab driver boasting about stock picking talents.
So although a cursory survey doesn’t bring up any “bubble flags”, it is not really possible to give a definitive answer. What can be said about the environment, however, is that there is a disconnect between investor sentiment and government policy.
In the U.S. (not withstanding the gradual tapering), monetary policy remains loose. This must mean that the Fed believes that the economy is not yet out of the woods. The buoyant stock market performance suggests that investors think otherwise. Someone is wrong and recent market activity would suggest that it might be the investor.
The lubricant came from “rocket scientists” devising complicated mathematical formulas to manage risk through a brilliant but flawed process of “tranching”, and rating agencies that blindly offered their seal of approval on the toxic investments.
Who would have thought that the credit agencies didn’t quite grasp the complexity of these instruments or that they were embroiled in all sorts of conflicts of interest with the very creators of the instruments? The unsuspecting investor didn’t really have any cause for concern. What makes a bubble so incredibly difficult to detect is that we cannot rely on past bubbles to identify new ones.
Every bubble is unique in the process of becoming one. With the internet bubble it was the farfetched notion that the internet had somehow created a “new economy” with vastly differing properties to the existing one. With the "altered" laws of physics, it didn’t matter much that a startup company in the Internet business2 could command stratospheric valuations and have no sales.
So just as with certain diseases, bubbles are notoriously elusive. Because of their very nature, it is usually too late when one realizes that he is in a bubble environment. Still, as with certain diseases, bubbles aren’t totally invisible, they do leave traces along the way.
An example of a detection tool for bubbles are the valuation multiples of stocks. When multiples of a broad index is way above its historical average, this can be suggestive of a bubble formation. Other similar ratios can also be used to provide additional clues.
Another, more subjective technique is to listen to all the chatter around you. The classic example is the cab driver that suddenly boasts about his or her skills in picking stocks and the killings made in the portfolio investments. Yet another example would be the frequency of the word “bubble” being mentioned in media or articles on the subject of bubbles at a given moment in time. Apparently, the more talk about bubbles in the media, the less likely it is that we are in one (so we should be worried when there is scant mention of bubbles).
Finally, there are the multitudes of objective or subjective measures (depending on how you look at it) that one can implement to detect bubbles. A good example would be to take the rolling average price of an investment and set a lagging two standard deviation limit above it. If and when the limit is breached, this could constitute a signal that a bubble may be forming.
All this talk begs the question as to whether the current market environment is one of a bubble or even conducive to its formation. Stock markets in developed economies have achieved record performances over the last year, multiples are significantly above historical averages in the U.S. and recent IPOs and acquisitions are in some ways reminiscent of the dotcom craze period of the late 90’s. To top it all off, corporate debt has soared as businesses tap into the attractively low interest rate environment, and private equity firms have had a record year in terms of cashing in on their investment portfolios.
Still, valuations are not exactly at insane levels (like they were during the dotcom craze), there doesn’t seem to be any particular segment of the economy that is behaving like the sky was the limit (as with the housing craze of the early 2000’s), inflation remains clearly subdued (and even deflationary in Europe) and I, at least, haven’t come across a cab driver boasting about stock picking talents.
So although a cursory survey doesn’t bring up any “bubble flags”, it is not really possible to give a definitive answer. What can be said about the environment, however, is that there is a disconnect between investor sentiment and government policy.
In the U.S. (not withstanding the gradual tapering), monetary policy remains loose. This must mean that the Fed believes that the economy is not yet out of the woods. The buoyant stock market performance suggests that investors think otherwise. Someone is wrong and recent market activity would suggest that it might be the investor.
