By Andrew Redleaf
Central to former Fed Chairman Alan Greenspan's desperate efforts to restore his place in history"”or at least to rewrite what currently looks like a pretty dismal chapter is the Greenspan Theory of Bubbles. The Greenspan Theory makes several propositions, but the most important is this:
No merely human mind is capable of identifying a bubble as a bubble until after it has popped.
A churlish reader of this proposition might detect some self-serving motivation, since it effectively excuses Mr. Greenspan from any responsibility for either the tech or housing bubbles, which otherwise dominate his legacy. But there is no need to go to motive to refute this proposition. We can think of no less than four signs that, taken together, suggest a bubble is a' blowing. All four of these marks of a true bubble were painfully obvious during both the tech and housing disasters:
1. Pervasiveness: In a true bubble, huge swathes of the public, people not ordinarily transfixed by investment markets, become caught up in the fever and alter their behavior so as to participate. That a now long forgotten Prudential securities analyst predicted, in late 1999, that Qualcomm stock would hit $1,000 was not infallible evidence of a bubble. That Qualcomm had become a hot topic of conversation not only at Manhattan cocktail parties but backyard barbecues in the heartland was. Ditto the constant real estate chatter of the last decade. When interest rates get more attention than box scores, that's a mark of a bubble.
2. On the shoulders of the bull: Pervasiveness takes time. Not all long-running bull markets become bubbles, but every bubble forms on top of a long-running bull market. Crucial to sucking in the general public is the gnawing fear of having missed the boat. The sideline crowd is rarely even aware of an ordinary, short-lived, and perhaps quite legitimate spike in prices. To get the mob's attention the thing has to go on long enough for them to notice, at which point it often seems like it will go on forever. By this measure the tech run was actually a bit on the short side. The NASDAQ did not begin to pull away dramatically from the Dow or the S&P until summer of 1998. But this was on top of a bull market that had been running for 16 years during which the NASDAQ more often than not was the center of the action. The bull market in housing began in late 1996, hit an inflection point in 2002, and did not pop until late 2006.
3. Prices dramatically detach from value: The notion that it is impossible to call a bubble is derivative of the notion that it is impossible to outguess the market on prices generally. It is certainly quite difficult to get prices more right than the market when those prices remain within a reasonably tight range"”say within one standard deviation"”of traditional valuation metrics such as Price to Earnings, or, in the case of price changes, within similar boundaries of asset class volatility. By late 1999 tech stock PEs exceeded historic norms by several standard deviations. From late 2003 onward annual housing price increases were multiple standard deviations above historic norms as reflected for instance by Robert Shiller's research showing long-term real increases in housing prices hovering at less than one percent.
4. Explanations and expectations: The final mark is that the explanations commonly offered for extraordinary prices range from the logically possible but extremely improbable to the flat-out incoherent. For a bubble to be sustained people must believe that prices will continue to deviate even further from historic norms. This requires progressively more improbable explanations for what is driving prices. The notion, popular during the tech boom, that the "new economy" was making price to earnings"”or for that matter any earnings at all"” irrelevant is the sort of inanity that becomes conventional wisdom in a true bubble.
The four marks of a true bubble identified both the tech and housing booms as the real thing. Ditto the Japanese equities and real estate boom. The run-up of U.S. equity prices from July 1985 though September 1987, on the other hand, did not obviously pass either the pervasiveness or the price/value tests. It also failed the most reliable after-the-fact bubble test: bubbles do not un-pop. The S&P regained ground quickly after the 1987 crash and was back above all-time highs within less than two years. The "nifty-fifty" craze of the late 60s and early 70s seems a better candidate, though perhaps we'd be more skeptical if we knew more about it. The very fact of an investment strategy becoming a popular slogan does suggest a bubbly environment.
Is there another bubble on the horizon? The commentariat wants to believe yes, perhaps because the last two were such great stories. Their three most popular candidates for the next one seem to be gold and commodities, sovereign claims, and China. I am skeptical on all three: people flee to gold and sovereign claims out of pessimism not irrational exuberance, and China still seems a bit too exotic to enthrall the heartland.
Andrew Redleaf is CEO of Whitebox Advisors and co-author of Panic: The Betrayal of Capitalism by Wall Street and Washington
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