stock market roller-coaster

Great article on bubbles; the definition of bubbles and the history of them. Kudos to my friend David Lau of for finding this this article. A special thanks to John Chew for giving me permission to reprint his article. he can be reached at [email protected]

Below is the article:

QUESTION: Do you think bubbles occur because of mass error, irrational exuberance, or both? (You’re not expected to know the definitive answer; just please share your opinion so as to start discussion.)

I believe bubbles occur because of mass error caused by “easy” money (increase in the money stock) and real rates manipulated below the originary (True time preference rate) rate of interest. The irrationality, greed, envy, fear are the human reactions or symptoms of the boom bust cycle.  Furthermore, in my opinion entrepreneurs are acting rationally to price signals given by the market, but the signals from the market are distorted by government intervention (interest rate/money stock) which causes mal-investment during the boom. The more government intervention thus the increase in size and frequency of the bubble cycles.

First a definition of a bubble

The term bubble is a frequently misused in reference to any category’s price that has appreciated—true bubbles are rare (pre-2010?!) A bubble, normally identified after it has burst, is the rapid increase and subsequent decrease in prices for a specific category of equity or commodity (e.g. technology stocks in 2000; energy in 1980 and housing prices in 2006)

A group of lemmings looks like a pack of individualists compared with Wall Street when it gets a concept in its teeth—Warren Buffett.

Increases in money stock and a negative real rate of interest will elongate and/or enhance the size of the boom phase; in other words, increase the mal-investment which shows up in too many internet start-ups, empty homes, over-supply of oil, etc.  The question becomes why does a particular asset class rise in price so sharply relative to other asset classes?  Typically when we speak of a boom we mean a boom in gold, housing prices, technology stocks, etc. We talk about a specific asset.  In the long run all industries and the assets within those industries must earn equivalent returns on capital because of the law of supply and demand (regression to the mean).  When there is some type of shock (invention, political action) that reduces supply and/or increases demand then prices will go up in that asset signaling entrepreneurs to marshal more assets/capital into that asset class or industry to meet the demand.

For example, when Netscape went public in 1996 the market for technology and telecom companies had a huge influx of demand because the browser opened up the product/service possibilities for those companies. Prices rose sharply for Netscape signaling high returns on investment which attracted resources to those industries. Now if the money stock remained the same then the resources would have to be moved entirely from other sectors of the economy. “Easy” money defined as the increase in money stock and the real rate of interest pushed below the originary rate (the true time preference rate of interest) distorts the signals of the market by flooding the hot industry/asset class with capital that otherwise wouldn’t be redeployed there. But since the capital is not fully being drawn from savings that would not necessarily be attracted there if the true time preference rate of interest prevailed, there is mal-investment.

The animal spirits, “irrational exuberance” are simply a symptom of the boom.  The initial high returns on a particular asset class will draw competitors into the industry to capture those “supra-normal” profits which will increase supply and thus force down the future returns in that industry causing the inevitable shake-out/bust.  Say the real return on assets is 8% in a steel mill but now demand pushes steel prices up whereby the steel mill can earn 16% on its capital.  Investors will rush to build and buy steel mills until the rate normalizes again.  Lawyers may wish to change professions and become mill workers.  People are reacting normally to these price signals they just don’t realize the prices are distortionary due to the artificially low rate of interest.

As Ludwig von Mises explains that when the central bank lowers interest rates below the natural rate of interest, engineered by an expansion in liquidity, the drop in interest rates falsifies the businessman’s calculation. … The result of such calculations is therefore misleading. They make some projects appear profitable and realizable which a correct calculation, based on an interest rate not manipulated by credit expansion, would have shown as unrealizable. Entrepreneurs embark upon the execution of such projects. Business activities are stimulated. A boom begins. (Human Action)

There seems to be a symmetry and proportion to bubbles perhaps due to the constancy of human nature.  Rising prices attract capital and supply, but in the near term—6 months, a year two or three?—price rises attract those who buy simply because prices are rising. Envy, momentum investors (buy and sell on price movement), the foolish buy without regard to the true “normalized” economic return of the asset.  Say home prices rise above what those homes could generate in market rents. If the normalized return for home rent is 5% given the alternative returns in the market then a $200,000 home would rent for $10,000 or $833 per month. If house prices doubled to $400,000 but the rent did not increase then the return would drop to 2.5%.   Either rent would need to rise, house prices fall or some combination to bring the capitalization rate into balance.  Perhaps, a house speculator who buys at $400,000 believes prices will double to $800,000 so the cap rate falls to 1.25%.  Perhaps they are being rational but the law of supply and demand in the long run is against them. On the other side, rising house prices attract home builders and speculators, but builders build only when lenders lend. Rising home prices increases the collateral value of which to make loans, larger loans allow for more building and the cycle goes until it stops. The ending is hard to predict, but end it will.

A Bubble is a bubble is a bubble from Markets, Mobs & Mayhem by Robert Menschel

Booms & Busts % Rise

Bull Phase

Length of Bull Phase (months) % Decline Peak to Trough Length of Bear Phase (months)
Tulips (1634-1637) Netherlands +5,900% 36 -93% 10
Mississippi Shares France (1719-1721) 6,200% 13 -99% 13
South Sea Shares England (1719-1721) 1,000% 18 -84% 6
American Stock (1923-1932) 345% 71 -87% 33
Mexican Stocks (1978 – 1982) 785% 30 -73% 18
Silver U.S. (1979 – 1982) 710% 12 -88% 24
Gulf Stocks Kuwait (1978 – 1986) 7,000% 36 -98% 30
Hong Kong Stocks (1970-1974)