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David's Macro Blog

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Archive for October, 2009

Is it possible that the great equity bubble of 2007 could fool the person best positioned to detect it?

Calculated Risk states in his post “A Comment on Fed Chairman Ben Bernanke” that Ben Bernanke misread the real estate bubble as Fed Governor, then as Chairman of the Presidential Council of Economic Advisers, and later as Federal Reserve Chairman.

How can Fed Chairman Ben Bernanke miss the biggest bubble in history?  Not only did he have the best education at Harvard, MIT, and Yale, but he also had access to all the data, experience, and team members that came with his powerful positions and titles.

In July 2005 Bernanke said:

“We’ve never had a decline in housing prices on a nationwide basis.  What I think is more likely is that house prices will slow, maybe stabilize … I don’t think it’s going to drive the economy too far from its full-employment path, though.”

From this one quote, made at the peak of the boom, we can see two things.  First, Ben did not believe that housing prices would fall much if any and that it was not conceivable that prices would fall across the country in all markets.  Secondly, any decline in housing prices would not slow the economy much to cause a significant increase in unemployment.

Now, just 4 years later we can see that we had the biggest housing boom (and bust) in history AND that the crash caused us to experience the unemployment unparalleled since the Great Depression.

In this case, a big trend (in asset prices and leverage) caused even the most well trained and experienced economic thinker, who has access to the best data, to get swept up and lose track of the fundamentals.

Why did this happen?  Share your opinion by commenting below.

Probably the biggest fundamental truth to any market is that markets rarely remain in perfect equilibrium Instead, markets (such as the real estate market from 1998 through 2009 or the stock market from 1996 through 2003) move through different stages of asset price levels, participant psyche, and fundamental value.

The following are what I observe to be the 6 changing stages of any market.

Stage #1: Pricing Supported by Fundamentals

  • Asset prices are in-line with historic norms.

Stage #2: Speculation Starts

  • Market participants identify the current trend and project that it will continue indefinitely — speculation starts.

Stage #3: “New” Pricing Justified

  • Asset prices are so distant from historic norms that they are justified by new economic theories.
  • For example, during the 1990’s tech bubble, higher price-earning ratios were justified and main stream media proclaimed that we were in a “new economy”.

Stage #4: Mania

  • When more and more buyers / speculators want to get in on the action, asset prices go through the roof.
  • Consequently, even “junk” sells as easily as quality assets as unsophisticated buyers are taken advantage of by deal promoters in sometimes fraudulent schemes.
  • Transaction volume and pricing reach levels that cannot be explained rationally.
  • For example, during the tech bubble many internet companies with no real revenue and/or profit went public with ridiculously high valuation (and failed quickly).  During the 2006 peak of the real estate market, “liar loans” and “flipping” were rampant.

Stage #5: Crash and Burn

  • There are few new buyers and no more “greater fools” so buying demand drops and asset prices fall rapidly and dramatically.

Stage #6: Never Again

  • Lessons are learned and new regulations are proposed or implemented to curb the abuses that “caused” the market crash.
  • Assset prices may be below long term economic value of the underlying asset.

However…

Despite many visible and memorable booms and busts, the odds are that we will NOT remember that market cycles exist; instead, most market participants will get caught up and participate in the next bubble.

“There is NO doubt that sometime in the future, we are going to have this conversation again.  It will not be for quite a period of time, but it will occur because the flaws in human nature are such that we can not change that.  It doesn’t work.”

– Alan Greenspan speaking in reference to the simultaneous collapse in the credit, stock and real estate markets in 2008.

Start over at Stage #1 and repeat the cycle.

What do you think?

Do you agree with the 6 stages I’ve identified?  What stage do you think we are in the real estate, stock or other markets you know of?  What are some market cycles you have observed in your lifetime?

Please comment and share your opinion.