Playing With Bubbles – Part 3: The Original Rodrigue Post

This is more of an “FYI” than anything else.

Below is a copy of the original 2006 post by Dr. Rodrigue, that includes that now famous (infamous?) Bubble Psychology chart.

Original source can be found here: http://people.hofstra.edu/jean-paul_rodrigue/jpr_blogs.html , about two-thirds of the way down the page.

(Oh, I’ve bolded parts that I think are particularly important to our current consideration of “Bubbles”)

Business cycles are a well understood concept commonly linked with technological innovations which often trigger a phase of investment and new opportunities in terms of market and employment. The outcome is economic expansion and as the technology matures and markets are saturated, expansion slows down. A phase of recession is then a likely possibility as a correction is required to clear the excess investment or capacity. The bottom line is that recessions are a normal condition to a market economy as they are regulating any excess, bankrupting the weakest players or those with the highest leverage.

What appears peculiar in the current context is that one of the mandates behind the creation of central banks is to fight a process that occurs “naturally”. The interference of central banks such as the Federal Reserve appear to be exaggerating the amplitude of bubbles and manias that fuel them. It could be argued that business cycles are being replaced by phases of booms and busts, which are still displaying a cyclic behavior, but subject to much more volatility. Although manias and bubbles have appeared many times before in history under very specific circumstances (Tulip Mania, South Sea Company, Mississippi Company, etc.), central banks appear to make matters worst by providing too much credit and being unable or unwilling to stop the process with things are getting out of control. Instead of economic stability regulated by market forces, monetary intervention creates long term instability for the sake of short term stability.

Are we now condemned to live in a world where fiat money constantly shifts from one bubble to the other? This remains to be seen, but I would argue that the destructive effects of a bubble’s blow off, like the current real estate bubble, could become strong enough to shake the foundations of a fractional reserve banking system, even one as large and as sophisticated as in the United States. Understanding how bubbles and their manias are created would certainly help.

Click here to download a PDF version of this figure (distribution permitted).

The different phases in a bubble are backed up by 500 years of economic history. Each time the situation is obviously different, but there are always a lot of similarities. The situation applies pretty well to the current real estate bubble, which is rapidly unfolding as these lines are written. Simplistically four phases can be identified:

1) Stealth. Those who understand the new fundamentals realize an emerging opportunity for substantial future appreciation, but at a substantial risk since their assumptions are so far unproven. So the “smart money” gets in, often quietly and cautiously. This category of investor tends to have better access to information and a higher capacity to understand it. Prices gradually increase, but often completely unnoticed by the general population. Larger and larger positions are established as the smart money start to better understand that the fundamentals are well grounded and that this asset is likely to experience significant future valuations.

2) Awareness. Many investors start to realize the momentum, bringing additional money in and pushing prices higher. There can be a short-lived sell off phase taking place as a few investors cash in their first profits (there could also be several sell off phases, each beginning at an higher level than the previous one). The smart money takes this opportunity to reinforce its existing positions. In the later stages of this phase the media starts to notice and those getting in are increasingly “unsophisticated”.

3) Mania. Everyone is noticing that prices are going up and the public jumps in for this “investment opportunity of a lifetime”. The expectation of future appreciation becomes a “no brainer” and a linear inference mentality sets in; future prices are a “guaranteed” extrapolation of past price appreciation, which of course goes against any conventional wisdom. This phase is however not about logic. Floods of money come in creating even greater expectations and pushing prices to stratospheric levels. The higher the price, the more investments pour in. Fairly unnoticed from the general public caught in this new frenzy, the smart money as well as many institutional investors are quietly pulling out and selling their assets to eager future bag holders. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep the appreciation – “the game” – going. The market gradually becomes more exuberant as “paper fortunes” are made and greed sets in. Everyone tries to jump in and new investors have absolutely no understanding of the market, its dynamic and fundamentals. Prices are simply bid up with all financial means possible, particularly leverage and debt. If the bubble is linked with lax sources of credit, then it will endure far longer than many observers would expect. At some point statements are made about entirely new fundamentals implying that a “permanent high plateau” has been reached to justify future price increases; the bubble is about to collapse.

4) Blow-off. A moment of epiphany (a trigger) arrives and everyone roughly at the same time realize that the situation has changed (like the Road Runner Coyote realizing he is about to fall after walking on thin air for a few seconds). Confidence and expectations encounter a paradigm shift, call it a reality check, not without a phase of denial where many try to reassure the public that this is just a temporary setback and that anyone saying otherwise does not know what he is talking about. Some are fooled, but not for long. Like a directionless herd many try to unload their assets to a greater fool, but takers are few; everyone is expecting further price declines. The house of cards collapses under its own weight and late comers (commonly the general public) are left to hold the bag while the smart money has pulled out a long time ago. Prices plummet at a rate much faster than the one that inflated the bubble. Many over-leveraged bag holders go bankrupt, triggering additional waves of sales. There is even the possibility that the valuation undershoots the long term mean, implying a significant buying opportunity. However, the general public at this point considers this sector as “the worst possible investment one can make in his life”. This is the time when the smart money starts acquiring assets at bargain bottom prices.

Bubbles can be very damaging, especially for those who arrived late with the hope of getting something for nothing. Even if they are inflationary events, the outcome of a bubble’s blow off is very deflationary as large quantities of capital vanish in the wave of bankruptcies they trigger. Historically, they tended to be far in-between, but over the last decade we have experienced the largest bubbles in human history back-to-back; the stock market (which deflated in 2000) and the real estate (which is likely to deflate in 2006).

…and, after writing this, the US Real Estate Sector collapsed in 2007. Well done Dr. Rodrigue.

What now for Australia (and perhaps many Asian centres, the UK and Canada?)

Well, for Australia, I personally believe we are in the vicinity of the “New Paradigm!” and “Back to Normal” phase; I have read both in the mainstream press in the last month or so, as the volumes of properties swell the supply-side of the market beyond expectation.

From this recent article (http://smh.domain.com.au/real-estate-news/blogs/property-values/bubble-or-paradigm-shift/20100921-15kwd.html) we have the following journalised paraphrase for Australia’s most largest mortgage lender, the Commonwealth Bank of Australia (“CBA”) – who by the way have over 60% of their loans in residential mortgages:

CBA, in their latest analysis, claim that a permanent structural shift has occurred to the way property markets operate.

(Emphasis mine)

Very much the “New Paradigm!” kind of language, don’t you think? (and there is certainly more where that came from!)

We’ll see what happens, eh? Hopefully it won’t be TOO painful for our record-indebted households…but I’m not too optimistic, I’m afraid…

Regards,

Stewart

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One Response to Playing With Bubbles – Part 3: The Original Rodrigue Post

  1. Pingback: Aussie Officials and The Aussie Housing Bubble (“not”) « Angles on Economics

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