Doom, Boom, Gloom
What does a bubble look like and how do they end? In a very interesting article James Montier of Societe Generale in London looks at not only the psychological analysis, but also at the propensity for commentators to continually proclaim the end of the problem and a resumption of business as usual. This makes for interesting reading, quoted from a US perspective, but not the less pertinent to the situation here in the UK.
To quote from his summary:
"We have seen the heads of virtually all financial institutions stand up over the last few months and claim the worst is behind us. Why would anyone listen to these people? They didn't see the disaster coming, and yet somehow they are qualified to tell us it is all alright! Perhaps I am just unduly sceptical, but this reeks of a conspiracy of optimism. The recession has barely started, let alone reached its nadir. The market moves of late have all the hallmarks of a classic sucker's rally. This isn't discounting the recovery, this is denial! Far from being behind us, the worst may well still be ahead!"
Montier say that he has long been proponents of the Kindleberger/Minsky framework for analysing bubbles. And that 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.
Euphoria
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.
Revulsion
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.
The first wave of concerns created by the bursting the housing/credit bubble (and make no mistake they are two sides of the same coin) is subsiding. The optimists believe (or at least hope) that the worst is now over.
However, from Montier's perspective such sanguinity is likely to be misplaced. The slowdown in the US is barely starting. Chart show that both the demand and supply for US credit are evaporating. This effective shutdown of both sides of the market should be a serious concern for monetary policy makers, as it is one of the hallmarks of a liquidity trap situation.
Obviously demand for mortgages (both commercial and residential) is lacking, but so is the demand for consumer credit, and corporate credit. This doesn't bode well for the outlook.
The underlying asset adjustment is likely to have much further to run as well. A chart of Japanese land prices during their bubble and burst illustrate the long drawn out nature of the healing that has to occur. And America appears still to be many years away from the end of this healing process.
Indeed, one of the lessons that should be learnt from the Japanese experience, he says, is that the banks were second round losers. They didn't really begin to underperform the rest of the market until the second Japanese recession of its debubbling process. They really started to suffer when their consumers started to struggle.
One of the other lessons of importance from Japan is that it is never the stocks that led you into the bubble that lead you out. For instance, in Japan's post bubble environment it was the capital-starved autos and electricals that were the winners. Just as the US market recovery after the dot com bubble wasn't led by tech but by mining, material and financials. Those deprived of capital do best in the aftermath of a bursting bubble, not those gorged on it. This argues that it isn't likely to be financials that lead us into any sustained rally.
This makes it all the harder to understand the way in which investors have been cheering the rights issues/capital raisings that financial firms have been carrying out. Montier recently described investors responses to rights issues as the investment equivalent of being mugged and then turning around and saying thank you to the perpetrator (and perhaps offering to take them to the cash point and get some more money out for them).
Rights issues, he says, are bad news for investors. The poor performance of firms conducting rights issues prior to the issue itself is clearly observable for the 1991-1995 sub-period. Even more noticeable is the increased underperformance once the rights issue is over. If history is any guide, investors cheering such issues now are likely to end up severely disappointed at the end of the day.
From our perspective Montier says, the market is enjoying a sucker's rally. The road to revulsion is likely to witness many such events, but the recession reality is only just unfolding. Far from being behind us, the worst may still be ahead!
I commend you if you have read this far! As a footnote Nogger was out lunching with a friend Sunday who works for a large national firm of UK estate agents. They had a meeting with their "mortgage specialist" last week who told them that a year ago he had something like 8,000 different mortgage products in his portfolio. Deals to suit everyone & their circumstances. Today he has around forty. All the others have been pulled. That's 99.5% of all mortgage products!
Completed sales in their office at the moment are around 50% of normal. She is not imminently worried about her job as she says they have so few staff if they shed any more then on some days the office would be empty! They have been told that there is enough money in the kitty to ride things out for another 18 months. Lets hope things improve before then.
To quote from his summary:
"We have seen the heads of virtually all financial institutions stand up over the last few months and claim the worst is behind us. Why would anyone listen to these people? They didn't see the disaster coming, and yet somehow they are qualified to tell us it is all alright! Perhaps I am just unduly sceptical, but this reeks of a conspiracy of optimism. The recession has barely started, let alone reached its nadir. The market moves of late have all the hallmarks of a classic sucker's rally. This isn't discounting the recovery, this is denial! Far from being behind us, the worst may well still be ahead!"
Montier say that he has long been proponents of the Kindleberger/Minsky framework for analysing bubbles. And that 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.
Euphoria
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.
Revulsion
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.
The first wave of concerns created by the bursting the housing/credit bubble (and make no mistake they are two sides of the same coin) is subsiding. The optimists believe (or at least hope) that the worst is now over.
However, from Montier's perspective such sanguinity is likely to be misplaced. The slowdown in the US is barely starting. Chart show that both the demand and supply for US credit are evaporating. This effective shutdown of both sides of the market should be a serious concern for monetary policy makers, as it is one of the hallmarks of a liquidity trap situation.
Obviously demand for mortgages (both commercial and residential) is lacking, but so is the demand for consumer credit, and corporate credit. This doesn't bode well for the outlook.
The underlying asset adjustment is likely to have much further to run as well. A chart of Japanese land prices during their bubble and burst illustrate the long drawn out nature of the healing that has to occur. And America appears still to be many years away from the end of this healing process.
Indeed, one of the lessons that should be learnt from the Japanese experience, he says, is that the banks were second round losers. They didn't really begin to underperform the rest of the market until the second Japanese recession of its debubbling process. They really started to suffer when their consumers started to struggle.
One of the other lessons of importance from Japan is that it is never the stocks that led you into the bubble that lead you out. For instance, in Japan's post bubble environment it was the capital-starved autos and electricals that were the winners. Just as the US market recovery after the dot com bubble wasn't led by tech but by mining, material and financials. Those deprived of capital do best in the aftermath of a bursting bubble, not those gorged on it. This argues that it isn't likely to be financials that lead us into any sustained rally.
This makes it all the harder to understand the way in which investors have been cheering the rights issues/capital raisings that financial firms have been carrying out. Montier recently described investors responses to rights issues as the investment equivalent of being mugged and then turning around and saying thank you to the perpetrator (and perhaps offering to take them to the cash point and get some more money out for them).
Rights issues, he says, are bad news for investors. The poor performance of firms conducting rights issues prior to the issue itself is clearly observable for the 1991-1995 sub-period. Even more noticeable is the increased underperformance once the rights issue is over. If history is any guide, investors cheering such issues now are likely to end up severely disappointed at the end of the day.
From our perspective Montier says, the market is enjoying a sucker's rally. The road to revulsion is likely to witness many such events, but the recession reality is only just unfolding. Far from being behind us, the worst may still be ahead!
I commend you if you have read this far! As a footnote Nogger was out lunching with a friend Sunday who works for a large national firm of UK estate agents. They had a meeting with their "mortgage specialist" last week who told them that a year ago he had something like 8,000 different mortgage products in his portfolio. Deals to suit everyone & their circumstances. Today he has around forty. All the others have been pulled. That's 99.5% of all mortgage products!
Completed sales in their office at the moment are around 50% of normal. She is not imminently worried about her job as she says they have so few staff if they shed any more then on some days the office would be empty! They have been told that there is enough money in the kitty to ride things out for another 18 months. Lets hope things improve before then.