Thursday, March 11, 2010
Wednesday, March 10, 2010
Here is a great piece from John Mauldin's site:
The Road To Revulsion
by James Montier
A couple of months ago I wrote a note arguing that events unfolding the in the US weren't a black swan but rather an example of a predictable surprise (see Mind Matters, 13 March 2008http://sgresearch.socgen.com/publication/strategy_periodical(20080313)_408.pdf). To claim the credit crisis as a black swan is to abdicate all responsibility for its occurrence. I argued that bubbles are a by-product of human behaviour, and that human behaviour is sadly all too predictable.
The details of each bubble are different but the general patterns remain very similar. As Marx said, history repeats itself, the first time as tragedy, the second time as farce. It is the general pattern of debubbling that I wish to explore this week, particularly in the context of the market's apparent attitude that the worst of the problems seem to be behind us.
Bubbles: a framework for analysis
We have long been proponents of the Kindleberger/Minsky framework for analysing bubbles (see Chapters 38 and 39 of Behavioural Investing for all the details). Essentially this model breaks a bubble's rise and fall into five phases as shown below.
Displacement - The birth of a boom
Displacement is generally an exogenous shock that triggers the creation of profit opportunities in some sectors, while closing down profit availability in other sectors. As long as the opportunities created are greater than those that get shut down, investment and production will pick up to exploit these new opportunities. Investment in both financial and physical assets is likely to occur. Effectively we are witnessing the birth of a boom.
Credit creation - The nurturing of a bubble
Just as fire can't grow without oxygen, so a boom needs liquidity to feed on. Minsky argued that monetary expansion and credit creation are largely endogenous to the system. That is to say, not only can money be created by existing banks but also by the formation of new banks, the development of new credit instruments and the expansion of personal credit outside the banking system.
Everyone starts to buy into the new era. Prices are seen as only capable of ever going up. Traditional valuation standards are abandoned, and new measures are introduced to justify the current price. A wave of overoptimism and overconfidence is unleashed, leading people to overestimate the gains, underestimate the risks and generally think they can control the situation.
Critical stage/Financial distress
The critical stage is often characterised by insiders cashing out, and is rapidly followed by financial distress, in which the excess leverage that has been built up during the boom becomes a major problem. Fraud also often emerges during this stage of the bubble's life.
This is the final stage of a bubble's life cycle. Investors are so scarred by the events in which they participated that they can no longer bring themselves to participate in the market at all.
Bull traps in bear markets
Of course, no debubbling process occurs in a straight line. They are punctuated by electrifying bull runs than end up as bear traps. I first came across the wonderful chart below in Marc Faber's Doom, Boom and Gloom report. It struck such a cord that I had to reproduce it here, taken from Colin Seymour's website.