does a bubble look like and how do they end? In this week's Outside the Box,
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. He includes a
fascinating piece from Marc Faber documenting the various quotes about how
well the economy was doing from 1928-32. This makes for fun, if a little sobering,
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
I think you will find this letter very interesting.
John Mauldin, Editor
Outside the Box
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 2008 http://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
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.
1. "We will not have any more crashes in our time."- John Maynard Keynes
in 1927 [NB: The authenticity of this one is a little suspect]
2. "I cannot help but raise a dissenting voice to statements that we are
living in a fool's paradise, and that prosperity in this country must necessarily
diminish and recede in the near future." - E. H. H. Simmons, President, New
York Stock Exchange, January 12, 1928
"There will be no interruption of our permanent prosperity." - Myron
E. Forbes, President, Pierce Arrow Motor Car Co., January 12, 1928
3. "No Congress of the United States ever assembled, on surveying the state
of the Union, has met with a more pleasing prospect than that which appears
at the present time. In the domestic field there is tranquility and contentment...and
the highest record of years of prosperity. In the foreign field there is
peace, the goodwill which comes from mutual understanding." - Calvin Coolidge
December 4, 1928
"When the financial and business history of 1929 is finally written, developments
of the past fortnight will occupy a prominent place in what will doubtless
be the chronicle of an exceptionally brilliant twelve month period." - The
New York Times, July 1929
"It becomes increasingly evident that, in many respects, 1929 will be written
into the commercial history of the country as the most remarkable year since
the World War in point of sustained demand for goods and services." - The
New York Times, August 1929:
4. "There may be a recession in stock prices, but not anything in the nature
of a crash." - Irving Fisher, leading U's. economist, New York Times, Sept.
"Stock prices will stay at high levels for years to come, says Ohio economist" -
The New York Times, II, Page 7, Col. 2, Oct 13, 1929
5. "Stock prices have reached what looks like a permanently high plateau.
I do not feel there will be soon if ever a 50 or 60 point break from present
levels, such as (bears) have predicted. I expect to see the stock market
a good deal higher than it is today within a few months." - Irving
Fisher, Ph.D. in economics, Oct. 17, 1929
The market went into decline until Monday, October 21st, 1929
"He dismissed yesterday's break in the market as a 'shaking out of the lunatic
fringe that attempts to speculate on margin.'" - Irving Fisher, The New York
Times, Oct. 22, 1929
"Security values in most instances were not inflated"
"The nation is marching along a permanently high plateau of prosperity"
"any fears that the price level of stocks might go down to where it was
in 1923 or earlier are not justified by present economic conditions"
- Irving Fisher, speech to a banking group, Oct. 23, 1929
"This crash is not going to have much effect on business."- Arthur Reynolds,
Chairman of Continental Illinois Bank of Chicago, October 24, 1929
Flashback to "Black Thursday," Oct. 24, 1929:
Stocks opened moderately steady in price, but traders whose margins were
exhausted began selling heavily... at one o'clock the stock ticker was recording
prices from half past eleven... stocks dropped 11% intra-day... After a bankers'
consortium sent NYSE Vice President Richard Whitney to the stock exchange
floor to offer to purchase in the neighborhood of twenty or thirty million
dollars' worth of stock at the previous selling price [most likely above
their quotations], the market eventually closed with only a 2% loss.
Ref: Only Yesterday: An Informal History of the 1920's, Frederick Lewis
Allen, Chap. XIII.
Not long after, the stock market plummeted in two days of panic: October
28 became known as "Black Monday" (13.47% decline in the Dow), and October
29 as "Black Tuesday" (11.73% decline in the Dow). Between October 23rd and
November 13th, 1929, the Dow fell by 39%.
"There will be no repetition of the break of yesterday... I have no fear
of another comparable decline."- Arthur W. Loasby (President of the Equitable
Trust Company), quoted in NYT, Friday, October 25, 1929
"We feel that fundamentally Wall Street is sound, and that for people who
can afford to pay for them outright, good stocks are cheap at these prices." -
Goodbody and Company market- letter quoted in The New York Times, Friday,
October 25, 1929
"The fundamental business of the country, that is production and distribution
of commodities, is on a sound and prosperous basis."- President Herbert Hoover,
October 25th, 1929
"They have lost a few tail feathers but in time they will grow again, longer
and more luxurious than the old ones." - The Wall Street Journal, between
Oct 24 and Oct 29, 1929
"The investor who purchases securities at this time with the discrimination
that as always is a condition of prudent investing may do so with confidence." -
New York Times, October 28, 1929
6. "This is the time to buy stocks. This is the time to recall the words
of the late J. P. Morgan... that any man who is bearish on America will go
broke. Within a few days there is likely to be a bear panic rather than a
bull panic. Many of the low prices as a result of this hysterical selling
are not likely to be reached again in many years." - R. W. McNeel, market
analyst, as quoted in the New York Herald Tribune, October 30, 1929
"Buying of sound, seasoned issues now will not be regretted" - E.
A. Pearce market letter quoted in the New York Herald Tribune, October 30,
"Some pretty intelligent people are now buying stocks... Unless we are to
have a panic -- which no one seriously believes, stocks have hit bottom." -
R. W. McNeal, financial analyst in October 1929
7. "The decline is in paper values, not in tangible goods and services...
America is now in the eighth year of prosperity as commercially defined.
The former great periods of prosperity in America averaged eleven years.
On this basis we now have three more years to go before the tailspin." -
Stuart Chase (American economist and author), NY Herald Tribune, November
"Hysteria has now disappeared from Wall Street."- The Times of London, November
"The Wall Street crash doesn't mean that there will be any general or serious
business depression... For six years American business has been diverting
a substantial part of its attention, its energies and its resources on the
speculative game... Now that irrelevant, alien and hazardous adventure is
over. Business has come home again, back to its job, providentially unscathed,
sound in wind and limb, financially stronger than ever before." Business
Week, November 2, 1929
"...despite its severity, we believe that the slump in stock prices will
prove an intermediate movement and not the precursor of a business depression
such as would entail prolonged further liquidation..." - Harvard Economic
Society (HES), November 2, 1929
8. "... a serious depression seems improbable; [we expect] recovery of business
next spring, with further improvement in the fall." - HES, November 10, 1929
"The end of the decline of the Stock Market will probably not be long, only
a few more days at most." - Irving Fisher, Professor of Economics at Yale
University, November 14, 1929
"In most of the cities and towns of this country, this Wall Street panic
will have no effect." Paul Block (President of the Block newspaper chain),
editorial, November 15, 1929
"Financial storm definitely passed." Bernard Baruch, cablegram to Winston
Churchill, November 15, 1929
9. "I see nothing in the present situation that is either menacing or warrants
pessimism... I have every confidence that there will be a revival of activity
in the spring, and that during this coming year the country will make steady
progress." - Andrew W. Mellon, U's. Secretary of the Treasury December 31,
"I am convinced that through these measures we have reestablished confidence." -
Herbert Hoover, December 1929
"[1930 will be] a splendid employment year." - U's. Dept. of Labor, New
Year's Forecast, December 1929
10. "For the immediate future, at least, the outlook (stocks) is bright." -
Irving Fisher, Ph.D. in Economics, in early 1930
11. "..'there are indications that the severest phase of the recession is
over..." - Harvard Economic Society (HES) Jan 18, 1930
12. "There is nothing in the situation to be disturbed about." -Secretary
of the Treasury Andrew Mellon, Feb 1930
13. "The spring of 1930 marks the end of a period of grave concern...American
business is steadily coming back to a normal level of prosperity." - Julius
Barnes, head of Hoover's National Business Survey Conference, Mar 16, 1930
"... the outlook continues favorable..." - HES Mar 29, 1930
14. "... the outlook is favorable..." - HES Apr 19, 1930
15."While the crash only took place six months ago, I am convinced we have
now passed through the worst -- and with continued unity of effort we shall
rapidly recover. There has been no significant bank or industrial failure.
That danger, too, is safely behind us." -Herbert Hoover, President
of the United States, May 1, 1930
"...by May or June the spring recovery forecast in our letters of last December
and November should clearly be apparent..." - HES May 17, 1930
"Gentleman, you have come sixty days too late. The depression is over."-
Herbert Hoover, responding to a delegation requesting a public works program
to help speed the recovery, June 1930
16. "... irregular and conflicting movements of business should soon give
way to a sustained recovery..." - HES June 28, 1930
17. "... the present depression has about spent its force..." - HES, Aug
18. "We are now near the end of the declining phase of the depression." -
HES Nov 15, 1930
19."Stabilization at [present] levels is clearly possible." - HES
Oct 31, 1931
20. "Executive Order 6102 Forbidding the Hoarding of Gold Coin, Gold Bullion
and Gold Certificates
By virtue of the authority vested in me by Section 5(b) of the Act of October
6, 1917, as amended by Section 2 of the Act of March 9, 1933, entitled "An
Act to provide relief in the existing national emergency in banking, and
for other purposes", in which amendatory Act Congress declared that a serious
emergency exists, I, Franklin D. Roosevelt, President of the United States
of America, do declare that said national emergency still continues to exist
and pursuant to said section to do hereby prohibit the hoarding of gold coin,
gold bullion, and gold certificates within the continental United States
by individuals, partnerships, associations and corporations and hereby prescribe
the following regulations for carrying out the purposes of the order...
All persons are hereby required to deliver on or before May 1, 1933, to
a Federal Reserve bank or a branch or agency thereof or to any member bank
of the Federal Reserve System all gold coin, gold bullion, and gold certificates
now owned by them or coming into their ownership on or before April 28, 1933,
except the following:
Such amount of gold as may be required for legitimate and customary use
in industry, profession or art within a reasonable time, including gold
prior to refining and stocks of gold in reasonable amounts for the usual
trade requirements of owners mining and refining such gold.
Gold coin and gold certificates in an amount not exceeding in the aggregate
$100.00 belonging to any one person; and gold coins having recognized special
value to collectors of rare and unusual coins.
Gold coin and bullion earmarked or held in trust for a recognized foreign
government or foreign central bank or the Bank for International Settlements.
Gold coin and bullion licensed for the other proper transactions (not
involving hoarding) including gold coin and gold bullion imported for the
re-export or held pending action on applications for export license..." Franklin
D. Roosevelt, The Whitehouse April 5, 1933 20 May 2008
The comments made every time the market rallies are characterised by the ever-present
optimism that we have discussed many times. I suspect that is exactly what
we are witnessing currently.
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. Indeed the
probability of a recession in 2008 has dropped to 39% on the Intrade contract!
However, from our perspective such sanguinity is likely to be misplaced. The
slowdown in the US is barely starting. The charts below show that both the
demand and supply for .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.
Note in particular how widespread the lack of demand for credit is, as well
as the supply! This isn't just about the housing market. 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.
The chart below shows the developments in US house prices and Japanese land
prices during their bubble and burst. The point of this chart isn't to say
that US prices will follow Japanese prices, but rather to illustrate the long
drawn out nature of the healing that has to occur. Indeed, one client recently
asked me if this was worse than the S&L crisis. To my mind it is much worse,
as securitisation was part of the solution to the S&L problems, whereas
it has been part of the problem in the build-up in this bubble.
Indeed, one of the lessons that should be learnt from the Japanese experience
is that the banks were second round losers, a point made by Albert Edwards
recently (see 3 April http://sgresearch.socgen.com/publication/strategy_update(20080403)_cc0.pdfGlobal
Strategy Weekly). 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 (Japan Inc) started to struggle.
From a market perspective, financials remain an exceptionally large component
of the market itself. As the chart below shows, today's 17% of market cap may
be well off the high of nearly 25% but remains a long way above the levels
before this bubble started.
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
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. I 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).
The chart below may just give some pause for thought. It comes from a study
by Capstaff et al1. They study the long-term performance of stocks conducting
rights issues in the UK between 1986 and 1995. In particular, they split out
the evidence in the pre 1991 and post 1991 periods. This is interesting because
it reveals two different motives for a right issue. During the first period,
it appears managers issued more equity to take advantage of high valuations.
However, the second period reflects a more separate need for cash brought on
by the last UK housing recession.
Regardless of the motive, the outcome is clear from even a cursory glance
at the chart below. Rights issues 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
From our perspective, 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!
1 Capstaff, Ngatuni and Marshall (2007) Long-term performance
following rights issues and open offers in the UK, available from www.ssrn.com
Your still thinking sell in May and go away analyst,
Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA)
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