David's Macro Blog

British humor we can all understand.

Somehow this seems to explain the situation better than CNBC. Why is that?

The belief in a recovery from the global economic collapse in 2008 has gained strength as the unemployment rate has leveled off, the stock market has recovered about 70% and real estate prices have stopped falling.

However, do we really have an organically growing economy or something else?

A great description of our recent economic experience comes from Bloomberg’s Caroline Baum:

Here’s a list of things we should expect in a true recovery:

• Increasing bank lending
• Growing credit use by consumers
• Increasing labor participation rate
• Increasing hours worked
• Increasing interest rates
• Decreasing unemployment (yes it is a lagging indicator)

Some far there is “no real muscle” because we don’t see any true signs of rebound in the economic and financial systems. Sure, the stimulus can temporarily bump up retail sales and the stock market, but long term it can’t.

Judge for yourself. Which do we have, an economy on life support or a real recovery?

In my opinion, we’ve been headed for a double dip recession ever since massive amount of stimulus was injected into the economy. Once that stimulus is removed, the double dip will commence. In reality we never left the first dip — we just momentarily suspended the decline.

Classical economics teaches that an economy, if properly managed, will remain in a state of equilibrium. This is because economists assume a perfect market place with rational actors who maximize their returns through their uniform access to all information.

As we know, the REAL world is much different from economic equations.

Instead, the real world economy moves through market cycles. These market cycles fluctuate between boom and bust as the market participants move through cycles of fear and greed and all sentiments in between.

The past 10 years have seen some amazing bubbles which were not sustainable because the asset prices got out of line with the underlying fundamentals supporting the market.

Let’s review the bubbles in our recent memory.

2000 Nasdaq index over 5000 – 9 years later the index is still off 60% from its peak.

2007 Real Estate Bubble – In just 2 years some markets are off 60% and the average is off 30%.

2008 Oil Price – The price per barrel peaked around $150 but then fell to under $40 in less than 2 years.

2009 US Treasuries??? If the future holds inflation then this may be just as large as the 2007 real estate bubble. However, if we continue with deflation, then maybe current yields are the new normal.

So, what bubble are we in now?

Please comment below and let me know what you think.

You might also like these posts on similar topics:

• Could our Fed Chairman miss the most obvious bubble in history?
  Ben Bernanke Fooled by the Bubble?
• Why the emotional roller coaster?
  Market Cycles from Euphoria to Despair and Back Again

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.

Here’s a good article with a very good description of the predictable economic cycle:
http://www.calculatedriskblog.com/2009/03/business-cycle-temporal-order.html

“The temporal ordering of the spending weakness is: residential investment, consumer durables, consumer nondurables and consumer services before the recession, and then, once the recession officially commences, business spending on the short-lived assets, equipment and software, and, last, business spending on the long-lived assets, offices and factories. The ordering in the recovery is exactly the same.”

From a macro perspective, we are already past most stages and are towards the last stages of reductions in business spending on long-lived assets and offices (property, plant, and equipment).