Chuck Ponzi November 27th, 2006

For at least a year, I have wanted to define a bubble for readers of this blog. The term is quite often misused, and like a disease is better defined by its symptoms. No, this is not a definitive work… I am sure there will be many who come after me who will be able to add information to the definition and description financial bubble or financial mania. Rather, this is an attempt to bring together the most important aspects of a financial bubble for those who are not widely read and do not have vast investing experience.

Sell My House Fast – Information at Swift Capital

This is not intended to prove that there is a bubble… there will be plenty of time to prove that. Especially since it is often difficult for the casual observer to detect a bubble except for after one has burst. This is just to define and describe what a housing or investing bubble is and would look like. There have been both bubbles in the past, and considering the reign of loose monetary policy of the past 10 years, it seems very likely we will have even more in the future.When defining a bubble, it is valuable to consider some of the attributes of an actual air bubble. Get out the kids’ bubble mix and blow a couple. You’ll notice that much like a snowflake, each one is completely unique, but they all have some consistent traits. They are filled with air. They appear invincible when blown because they can be pushed, handled, flicked, or blown. While bubbles can pop from forced air, they often can float along in normal circumstances without immediately popping for quite some time. Their walls appear strong at first, but with time weaken, and they always, always pop, it’s only a matter of time. Size in relationship to wall thickness is also a primary factor in popping… the larger they get, the more imminent the pop.

With that said, let’s discuss the required components of any bubble:

Speculation
What is a bubble filled with? In the conventional world, it is air. So, to begin our discussion, what is speculation, and why would it be like air? The unabridged dictionary.com’s dictionary defines speculation as follows:

Engagement in business transactions involving considerable risk but offering the chance of large gains, esp. trading in commodities, stocks, etc., in the hope of profit from changes in the market price.

Notice both the method (transactions involving considerable risk), the goal (large gains), and mechanism (changes in the market price). You might contrast this with a definition of investment:

the investing of money or capital in order to gain profitable returns, as interest, income, or appreciation in value.

You will notice some key differences here: investing vs. considerable risk; profitable returns vs large gains; and, interest, income, or value appreciation vs. changes in market price.

The primary difference between investment and speculation lies in the expected outcome of the risk-taker, not in the mechanisms by which the transaction takes place. Whereas an investor might purchase an asset for its ability to return regular dividends, a speculator would primarily be interested in later selling the asset to another party at a higher price. There is no time constraint to speculation per se, but generally, shorter periods of time are a speculator’s general intention. This is key when considering the mindset of homebuyers of the last 5 years. At one point, home prices were largely dictated by the investor mindset, in other words, the rental income of a property (or opportunity cost of renting an equivalent property for the owner) could largely cover the monthly expenses and return a reasonable regular return (without selling the asset) that matched the correlated risk the holder was exposed to. An investor is primarily concerned with the long-term, and does not readily consider the market price, but rather the value of regular returns. A speculator’s entire purchase, on the other hand, is governed by whether or not a later sale can be executed at a higher price.

Speculation is impulsive, and requires a further impulsive buyer; most successful speculation occurs when a temporary shortage or glut causes wide price swings in a shallow market. Deeper markets can absorb temporary supply shocks when investors put off purchases for a period of time. Shallow markets, on the other hand have more volatile swings due to the size of bid and ask lots being inconsistent. Excellent examples of shallow markets are thinly traded stocks or local housing markets. While in deeply traded markets, large price volatility tends to be minimized and relegated primarily to impairment (large earnings shocks vs. consensus expectations), shallow markets can experience price volatility not only from these shocks, but also seemingly benign events such as increased availability of the shortage product compared with demand, or even speculator psychology. This is exactly why areas with high growth tend to experience high price volatility… even small changes in psychology can cause speculators to pack the exits, or gobble up as much as they can get their hands on. Thinly traded markets cannot respond to the ask, and transactions only occur on the sharply downward sloping margin of long-term investors. Bubbles are more easily formed in shallow markets because once an underlying change happens, the entrenched expectation of higher prices in the future creates a self-fulfilling prophecy until the demand exhausts itself. It’s also easy to note that shallow markets initially pop in volume (low volume) immediately prior to price drops.

Because of these factors, one can compare air inside a bubble to speculation. It can be influenced easily by outside forces. In some cases, speculators are perfectly manipulatable… for example, deep-pocketed investors wanting to buy shares on the cheap can easily shake out speculators on thinly traded stocks. Once manipulated speculators, like air, disappear into the market from whence they came. As if it had never existed in the first place.

To investors, fundamental value is primary. To a speculator fundamental value is folly, meaning nothing, and having no worth; the purchase price and sales price are the primary considerations. For an investor, the entire purchase is weighed against alternative investments in various asset classes; everything from risk-free treasuries to junk bonds, to Fortune 100 stocks to startup biotech stocks, from condos to mansions; all with the sole purpose of generating long-term returns for the investor with a reasonable balance of risk of loss to reward.

Every asset has a component of potential cash flow or wealth protection. In stocks, it is dividends or free cash flow discount model. In real estate, it is the discounted rental value. In precious metals, it is primarily a value protection strategy. Every asset class that has value has an intrinsic value based on assumptions that the investors attempt to quantify, discount the present value, and compare against existing prices. Speculation, on the other hand, does not care about intrinsic value, it is expected that a later, higher strike price will allow the speculator to sell and receive a profit, primarily for risk taking and time.

Price Volatility in relation to underlying fundamentals
Price volatility in and of itself does not necessarily signal a “bubble” per se. There are a number of situations where rapidly advancing prices stuck for a long time based on fundamentals. Evenso, Bubbles do not necessarily require a price run-up. In theory, if the fundamentals increasingly deteriorate, the current price that stays put is actually forming a bubble.

In stock bubbles, this is a detachment from price-to-earnings ratios. In housing it is a detachment from rental value. In precious metals, it is the cost to mine and refine (or create) more. In all cases, the fundamental value is based on the discounted cash flows from the future or cost of replacement, whichever is lower. I include the caveat of whichever is lower because assets can be impaired – have future cash flows removed – by external forces, and most things can be compared to like-kind assets that serve as substitutes.

This detachment from fundamentals rarely occurs in the base portion of an asset bubble. In fact, the base serves as an initial reasoning for the later speculation frenzy. It is only when the psychological component of the ever-increasing price of an asset becomes entrenched in participants’ minds that the detatchment occurs. In most cases in history, a bubble is preceded by a legitimate shortage of the bubble asset. This shortage is always temporary, since more can be made, refined, or a substitute provided. Humankind has yet to find a shortage in any asset that cannt be replaced with a suitable substitute. However, it is that original pattern of fundamentals that supports the later mania… short-term history must support the wild speculation with abandon. Else, if risk enters the minds of participants, the asset quickly falls back into alignment with fundamentals. It is only when participants believe that fundamentals don’t matter, that financial bubbles can be defined.

Psychological mania
Greed, while present during a bubble, is also not a sign of a bubble. It is the wild abandon with which greed posesses an otherwise rational mind and drives them to excesses which men or women under normal circumstances would abhor. Greed is a required component of a bubble.

Correlation, however is not causation. Consider a scientist who does experiments on men who eat onions and observes that these men have nearly half the incidence of heart attacks. However, was it really the onions which provided better heart health? Perhaps these men were predisposed to a healthier lifestyle with a higher intake of raw vegetables which was the actual primary determinant. Or, perhaps their chronic bad breath reduced their likelihood to marry a nagging wife? Either way, eating onions would not necessarily be the cause of better heart health simply because there is a correlation. There must be a logical direct link between a cause and effect.

However, greed is a human condition that exists during all economic periods. It is not relegated solely to bubble markets.

Participants must believe wholeheartedly in the inability of the asset to be constrained by fundamental beliefs. Some might even compare this with religion, however irrationality is so strong in a financial mania that even when participants are presented with irrefutable proof of its existence, they wipe away the facts as personal biases. No longer do facts reign, but a filter is placed on participants’ minds. Only the good news filters through.

It is important that any investor keep an even keel to make rational decisions about the present value of an investment. The same as it is with any asset. When someone says that it is always a good time to buy, or a good time to sell (an asset), that irrationality has sunk in.

The most fundamental concept of investing is the concept of timing. The most fundamental flaw in most participants logic is that the asset provides more than just money… everything that costs money is an investment and can be traded again for money, nothing more.

Oftentimes, those attempting to prove that a bubble exists can easily pass over this critical component… it is often the strongest of all forces within a financial mania. No financial bubble ever existed without a convicted audience promoting the asset until it collapses.

Abundant lending or enabling forces
Speculators often commit very little personal wealth to the speculative endeavor… because it involves substantial risk and human nature seeks to manage risk. Speculators seek out opportunities to capture large gains and minimize losses as much as possible. Akin to chewing off a limb when stuck in a trap so that the body is released, the speculator seeks to minimize the downside effects of a false step. This is not to say that investors would do otherwise, but rather the impulsive nature of speculation requires the participant to place something in harm’s way. Investors generally seek to avoid the risky situation altogether or find situations where long-term perseverance wins out for the intended objective. Investors can and often will wait out a temporary downturn; speculators cannot and will not since their risk and commitment has been minimized.

In financial bubbles, the primary enabling force has been unsecured lending. Unsecured in the sense that the loss has no recourse to the borrower’s personal assets, only the investment asset. In the case of stock bubbes, this is often buying equities on margin. In housing, it is low-down lending. However, it must be noted that late in speculative bubbles, participants become more and more daring, committing ever larger personal stakes in their endeavors, causing the eventual downturn when transaction velocities crumble.

Because the speculator has little committed, their returns can be multiplied when the transaction favors their business. On the other hand, in highly leveraged bubbles, speculators only lose their minimal investment. It is that lack of personal responsibility and personal investment that causes participants to take greater and greater risks, believing that the investment ALWAYS goes up. Then, if something causes the price to go down, most believe it is temporary, or internalize the cause. This is why financial bubbles end in pops… early signals for speculators to exit are ignored until it is too late.

The Bubble Defined
Financial manias are primarily psychological events, however since psychology (like air in a bubble) is not easily measured, other attributes must be observed to determine if a bubble or financial mania exists. Like a real bubble, it is only a matter of time before a financial bubble pops.

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