 Saturday, May 4, 2002
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Contributing Editor Daan Jourbert forwards this tongue in cheek look at understanding the stock market and the forces behind it. The essay is the first of a two part series. The essay is styled as material for a college course.
Name of module: Pricking Bubbles Slowly 101
Course requirements: Growing Bubbles 101, 102, 6 months experience as a day trader
Reference materials: These course notes, Speeches of Federal Reserve Board Chairmen
Description: This is an extra-curricular module that is recommended to all students who intend to follow a career in Government with the intention of reaching the top of the pyramid, or who aspire to becoming a member of staff for an incumbent in Congress.
The ‘Why’ of Market bubbles
Lecture 1
Dann Jourbert
Of Bubbles: Introduction
Market bubbles develop when a bull market lasts too long and develops an immortality complex.
As a rule, bull markets are a very good thing. They are good for the economy and for investors and for consumers. Bull markets on Wall Street are particularly loved by the Politicians, who see their chances for re-election improving the more the bull snorts.
Bubbles are bull markets in stampede - out of control and potentially very damaging. At first, a bubble is very good for investors and even better for Politicians; it may even seem for some time that it is good for everyone, except those unfortunates who have missed the boat. But a real bubble not so good for the economy. All kinds of less obvious imbalances develop that selectively might be good subject material for speeches by Important People, who look on the bright side of the balance and say, "See, things have never been better." But sooner or later these imbalances are really very bad for the economy.
For an economy to blossom over the longer term, the many imbalances that develop as a consequence of a bubble have to be corrected. This requires that the market bubble be deflated slowly. If the bubble should burst under the treatment, it is bad for the economy and really bad for investors, often known as traders and sometimes even as speculators. A pricked bubble and its consequences are terribly bad for the Politicians whose party is governing at the time of the prick, but very good for the Politicians in opposition as it ensures a landslide in their favour at the next election.
This module is concerned with the matter of pricking a bubble slowly.
Growing a bubble
Students are referred to the contents of Growing Bubbles 101 & 102 to refresh their memories of how bubbles are cultivated.
To recap briefly, there is strong evidence of a long lasting business cycle of growth and recession, one that is also reflected in the stock market. The stock market is an animal with a dual nature - on the one hand it is a very important cylinder in the engine of the economy and on the other hand the stock market also acts as its barometer, or perhaps its speedometer.
There are highly astute people in various Government agencies and organisations who are charged, openly or covertly, with the task of protecting the currency against onslaughts from without, or even from within. The task of keeping the national currency healthy is, however, in some instances also interpreted as a responsibility for keeping the economy growing strongly. Presumably that is perceived as a prerequisite for a stable currency.
Yet, until comparatively recently and despite the efforts of these knowledgeable people, the waxing and waning of stock market indices show how an economy would enter a growth phase and remain there for 3-5 years, sometimes a little longer, and then it seems the inevitable declining phase sets in and it lasts from say 18 months to about 3 years.
A major reason for the business cycle is found in consumer psychology. People always wants a little more of the good things in life than they can afford. When the economy begins to bloom, consumers get confident that the good times are here to roll and they make new debt at a faster rate than the increase in their incomes. Of course, this rapid ballooning of consumer debt load helps to boost the freshly expanding economy out of the previous slump and it is therefore perceived as a Good Thing, to be encouraged by a lax monetary policy, low interest rates and easy credit.
All in the hope that Wall Street will launch itself into a bull market, which, as noted above is a Really Good Thing. And as hope springs eternal so we often find that markets quite frequently embark upon a bull market that makes everyone except a few hard-core bears very happy indeed. But all is not sunshine and roses, because like all good things most bull makets come to an end.
Sonner or, hopefully, not later, the consequences begin to gather. Production begins to lag behind the growth in demand and prices start to rise faster. Inflation sets in and authorities are forced to lift interest rates. Consumers are squeezed by the cost of servicing both their debt and their desire to own more pretty things and thus ask for more money from their employers. Inflation speeds up and rates follow and soon the market goes into bear mode - generally without reaching the bubble stage. The decline is quite moderate and as soon as the proportion of debt has fallen to a more comfortable level against income, the pump is ready to be primed for a new cycle.
So it goes. Most of the time, at least.
It is the exception where the bull market does not end, but strives for immortality that is our concern.
A maturing Bubble
It follows that for a bull market to extend longer than its natural time span, the near inevitable rise in prices and then in interest rates has to be prevented. Which implies that the economy has to be actively nurtured and coddled by the authorities. There are three requirements for this to happen, apart from political rhetoric that is - which, like the hot air it resembles and despite the firm beliefs of the party in power, actually has little to do with keeping the bull alive.
One is a banking system with very loose purse strings and the second is a strong currency so that foreigners are happy to entrust their savings to local financial markets. The third follows in part from the second, assisted by the Bull Market. A strong currency helps to keep prices in check, particularly if much of the goods on the shelves and show-room floors come from across the borders. A bull market on Wall Street absorbs all the extra cash so that consumer prices remain tame enough not to be a concern.
In combination, these three things keep the credit bubble growing without much pain to consumer (often called ‘sheeple’, but this term should strictly be used only for consumers who are also active traders in equities, often using margin.)
Of course, it also does not harm the cause when cheap imports and the threat of foreign competition keep the local workers from pushing for wage increases.
Unfortunately, the political advantages of a flourishing bull market are put at risk when the bull lasts long enough to suffer the delusion of immortality; it then transform itself into a bubble. Typically, this is a gradual process of sectoral discrimination where one group of stocks is preferred to most others. This happens not because that group is really performing better than the rest, but because there develops a collective perception among analysts and investors that the group as whole will be able to corner a significant portion of the national economy at some point in the future.
This perception is usually based on some breakthrough technology that triggers estimates of future growth in the new market that is opened up by that technology that analysts - and investors! - investors find irresistible. As time passes, the group of freshly popular stocks diminish in size and the pursuit of the few remaining favourites become more frenzied. PE’s reach really impressive numbers and these stellar valuations are justified by even more optimistic estimates of the size of future market growth.
Analysis of forecasted market and earnings growth by and for the members of this group will show that while the potential for growth is really impressive, analyses are inherently flawed. Assuming realistic assumptions of the future size of the market, calculations will show that the high PE’s of top companies are predicated on each of them obtaining a very significant share of the whole market, if not of the global economy.
Given the existence of this flaw in the foundation of the bubble edifice, it is a matter of time before people apprehend the absurdity of it all and decide to sell and hold out. When enough people do so, the market cannot sustain itself and then the ugly "C’-word gets mentioned more and more until it manifests itself.
It is in the nature of bubbles to end quite rapidly, as time in markets is measured. When a bubble collapses (and no, that is not the "c"-word referred to above), it does not take place slowly like a tire with a nail in it deflating. It happens more like an over-blown balloon that believed itself to be pin-proof and decided to prove this belief with a test.
After the event, the outlook for the economy as a whole as well as the odds for re-election of the governing party, closely resemble the remains of the balloon - just tatters.
So too, of course, does the financial condition of most households. Loans taken on to invest in stocks do not disappear when these get delisted from the NYSE or Nasdaq.
The challenge of keeping the bubble essentially intact - and thus also the reputation of the Politicians in power - while gradually toning down the excesses that have developed, so that the fatal meeting of bubble and pin can be avoided, or, at worst, delayed until after the next election, is the subject of Pricking bubbles slowly 101.
The objectives of this module
Bubbles are terribly robust, up to a point. A bubble doesn’t jump around, waving arms and shouting, "Look at me! I’m a market bubble!" A bubble masquerades as a beautiful and long lasting bull market. A sign that the new technology of the day, with the Right People at the economic helm, will ensure a growing economy for many years to come. It is generally described as "The New Paradigm" that supersedes the way the economy used to operate and, because of that, requires new, flexible and innovative measures from the Authorities not to stifle or smother the growth potential of the "New Economy"..
What drives the New Paradigm can vary widely; a new and beautiful flower or perhaps expansion into virgin lands; more recently it has been a break-through in technology that opens up new markets and unlocks vast potential for growth for the early birds in that new market - be these the railroads, the automobile and radio, computers and electronics, and even more recently the internet. Tomorrow it is likely to be the Service Economy that is all the rave.
Once the façade of the bull market starts to crumble to reveal the fragility of the actual bubble behind it, often under a sustained assault from increasing interest rates, the end and final collapse can be very abrupt, very steep and most devastating.
The objective of this module is to discuss ways and means of preventing this sudden and mortal collapse in the market, known as a Market Crash. Market Crashes wipe out so much wealth and brings so much financial misery in their wake that the economy takes years to recover. Even the Politicians who come into power in the wake of the Crash find it difficult for many years to retain the confidence of voters who grovel in misery.
Engineering a soft landing
We now come to an overview of the process of "Pricking a bubble slowly." Detail on some of the measures are given in a second chapter.
The process of pricking a bubble slowly is euphemistically known as "Engineering a soft landing." This makes it sounds as normal and everyday as a passenger plane touching down after a long flight high in the blue sky. Nothing to get excited about or to consider as anything but standard operating procedure. Just leave it all to the economic engineers.
Rule 1: Keep the purse strings loose.
A primary cause of any bubble is a lax monetary policy. It follows that probably the most important rule for this engineering process is to keep on pumping cash into the system.
It is essential, though, that changing circumstances in the New Economy be used justify the high growth in the money supply in order to conceal the true motive. One does not want people who sit in the economic kindergarten to ask why the Emperor can break one of the most basic rules of economics and expect to get away with it. The justification and explanation has to be consistent and constant, so that it is not questioned at all.
Of great assistance during this effort will be the ruling Politicians, who are well aware how their bread is buttered and that a Crash will annihilate their chances for re-election - as sure as bread falls buttered side down. They will trumpet all they can in support of the bluff so that they can later point out with pride how well they have managed the economy and how rich the voters have become. (Some, of course, will not be aware it is a bluff.)
If at any time the statistical radar spots an approaching pin on the horizon, two things are essential. The first is to modify the statistics and the second is to continue and even speed up the flow of funds from the banks through the wallets of the consumers to the economy at large and also into the stock market. The pretense of a strongly expanding economy with low inflation has to be maintained at all costs. In this way low interest rates can help to maintain a high debt ceiling, a factor that prompts consumers to borrow more and into spending freely and eagerly. Even if the household finally does so out of desperation and a feeling of, "We are so deep into debt now that if we make another few loans and all the promises do not come true, it will be the banks’ problems; not ours."
If push comes to shove and consumers need that final kick in the pants to get them out of the house and spending, there is one thing the average consumer cannot resist - buying a bargain. Just think for yourself what a wonderful feeling it is - to walk into the home and say, "Darling, just come and see this bargain I picked up today." And then ever so much better if one can add, "And the interest rate is zero."
Bargains and zero rates - it will be the exceptional (or very desperate) consumer that can resist a visit to the local auto dealer or the marina where that pretty new model boat is up for sale, or to the interior decorator or the audio shop for that brand new TV-cum-home entertainment console. Or to buy a faster computer with which to visit all the web-sites on the internet of corporations where the trader owns a little bitty part of the action!
Rule 2: Forge an alliance with the media
A second essential ingredient for success is to have the media on your side.
Luckily, this is quite easy to accomplish. In fact, the Soft Landing Engineer (SLE) has to beat away the members of the media with a club before they will cease to talk the market higher. Not that he isn’t pleased with the way they are performing! As if they got paid to do just that.
One should keep in mind that throughout the bull market and the bubble that followed, familiar talking heads on the business and financial TV channels have built their lucrative careers on the premise that the "bull market" is here to stay. By the time the bubble begins to shows signs of strain, they and most of the writers in printed media had been "correct" in their views and analyses for so many years that it is unthinkable, and perhaps even impossible, for them to sing to any other tune.
Even just trying to warn of a possible end to the bull could have such a traumatic effect on viewers out there, and thus on network management as well, that the entire carefully nurtured career of a talking head could implode into dust after just a brief indiscretion. If events later proved such a warning wrong, they would repent the mistake throughout a long life of poverty. Yet, if events proved them right and the bubble did get pricked, they would carry direct blame for the Crash till the day they die. Also in poverty.
In either case they would be history as far as any network is concerned.
So, with a good and steady money supply to keep on feeding the market and consumer spending, and the national propaganda machine working very much in your favour as the SLE in charge, what else do you need?
Rule 3: Establish a Crash Prevention Team (CPT).
The higher the PE’s of the leading stocks, the more vulnerable they become to Bad News. Bad News can assume many guises, but the worst is the really bad news of a jump in interest rates. Higher interest rates become the pin that can prick the Bubble because of their effects on four fronts.
Higher interest rates add to the expense of conducting a business, reducing future profits and thus lowering the PE that the stock can command. Secondly, consumer debt becomes more expensive; this lowers the debt ceiling that consumers can afford and therefore their ability to keep on spending.
Thirdly, with debt becoming more expensive, consumers become tempted to sell their investment in equities when they want to purchase the new car or go on an overseas trip, rather than to make new debt for this purpose. A wave of selling of equities is the last thing the Bubble needs.
Fourthly, higher interest rates mean a higher discount rate has to be used for the stream of future earnings in the valuation of the current worth of a stock. A lower valuation means that the PE’s of many leading stocks appear even more ludicrous than they already do. At some point in time a few of the commentators in the popular media might discover this and then comment on the fact that the Emperor is not wearing anything at all. And for that message to be broadcast is what the Bubble wants least of all.
Since all Bad News can not be anticipated and countered all the time, there are bound to be instances when the market takes a sudden dip which threatens to become a complete sell-off. It could even become a fully fledged Market Crash.
This is something that has to be prevented at all costs, else all the hard work nurturing the Bubble over so many years will have been completely in vain. And the Politicians who will now lose the next election will be exceedingly angry. Even the other Politicians who win the election will not be happy, since it will require more time than their term in office to put the economic Humpty Dumpty together again.
Which means they may lose the next election in turn and hand their opposition all the credit for the recovery that begins during their new term in office.
And all SLE’s know it is very, even exceedingly, bad form to bite the hand that gives you opportunity to earn your daily bread with so little real effort. It is something that comes back to haunt one when out looking for work. Any work.
© 2002 Daan Joubert
[This is a slightly updated version of an article that appeared at www.gold-eagle.com early in 2000]
Next: Pricking Bubbles Slowly 102: The operation of the CPT, or actively preventing a Market Crash.
More by DAAN JOUBERT
