Rodney Johnson | Wednesday, January 16, 2013 >>
Remember years ago when the markets were steady, the fundamentals were sound, and governments around the world were not trying to manipulate the business cycle?
In fact, looking back through history it’s difficult to pinpoint times when at least some of these things were not going on and when the cycle of growth-mania-implosion-growth wasn’t in play.
If we look across asset classes – stocks, bonds, metals, grains, energy and real estate – there is always one area that is zooming well beyond any reasonable valuation… only to soon be followed by a devastating crash.
If this is so common, and has been around since at least the Dutch Tulip mania and the John Law Mississippi Land Company, then the question becomes, “Why does it keep happening?”
Why do people, in the form of constituents, investors, savers and citizens, keep allowing markets and economies to zoom out of control?
The answer is, “We’re all crazy.”
Or at least, we are all irrational.
In each case there is a situation – like the Iranian oil embargo, the Internet craze, wild credit lending and Fed intervention – that precipitates a market run, but people act as if it’s normal… like it will continue forever. And then it doesn’t.
We know the cycle, we can cite numerous historical examples, and yet we fall for it over and over again.
We’re crazy, right?!
Maybe, or maybe we’re just human.
Part of the human make up is mental conditioning that gives our most recent experience the greatest weight in our judgment of what will happen…or should happen… in the future.
Think of all the people whose homes doubled in value from 2000 to 2005, but then “lost” half their value through 2010. On paper they are back to where they started… no harm, no foul. But in the minds of those people they are much poorer.
The same is true with income. If a person gets a raise from $80,000 in salary to $100,000, they feel great. If, a year later, that same person has to find a new job, but can only find one at $80,000, they feel undervalued.
In economic terms, Hyman Minsky played off of this mental conditioning to state that stability creates instability. His point was that when any market stabilizes, market participants begin to underappreciate risk. This lack of appreciation shows itself when people take on ever greater levels of risk in markets that have already made outsized gains.
Again, the housing market is a great example…
With valuations flying high in 2003-2004, well beyond traditional measures of affordability and long-term growth, it would seem obvious (in hindsight) that the market was ripe for a fall. Yet people kept buying. Why?
Well, every day they got up, looked at the world around them, and saw that prices had once again moved higher. This brings back the old Groucho Marx question of, “Who are you going to believe, me or your own eyes?” A person could read about the perils of the housing market all day, or even hear the warning bells in his own head, but the prices on the ground kept moving higher. The risk seemed minimal indeed.
The interesting part is that there is so much written in defense of huge moves in markets. It is always the “new normal.”
Gold was going not to $800, but $1,500, in 1980. Housing was going to remain at high levels and even move higher because of the stable interest rate market and growing population. Oil was going to stay well above $125/barrel in 2008 because of Chinese demand.
There’s always a reason for markets to remain at lofty levels, and even go higher. The thing is they rarely do.
Unfortunately, it is the odd example of a permanent move that gives people some hope that this time really is different. For example, the oil embargo after the 1973 war in the Middle East permanently changed the structure of oil pricing.
Tectonic shifts like this are rare, even though people seem to see them in every market that is currently out of whack.
So when markets do finally break down, the fall is rarely gentle. Instead, prices and values come crashing to the ground as market participants all try to squeeze through the exit door at the same time, like all the depositors standing in the Bailey Savings and Loan in the movie “It’s a Wonderful Life.” It was a panic, and people were willing to sell their shares at a great discount simply to be out.
We see examples of booms and busts all around us, from idle container ships to natural gas fracking activities.
The forces that drive these trends reside in our heads.
As long as markets are made up of people, we can expect the boom and bust cycle to continue.
For us as investors, this is a wonderful thing! Just think how boring it would be if all markets were calm and steady. There would be no advantage gained from analysis, as all risk/return would be equalized across asset classes. Everyone would have the exact same outcome along the continuum of risk… at which point, I suspect people would begin to make up risk just to relieve our minds from the monotony!
Luckily for us, we have plenty of markets out of whack right now to keep us occupied.
Off kilter markets, driven by outside forces or overly aggressive investment trends, are what we look for in our Boom and Bust portfolios. Whether we are on the long side of the trade, with infrastructure companies that pay handsome dividends, or on the short side, where we have a dim view of certain bond markets, the goal is the same.
We use our long-term economic research to inform our short-term analysis… looking for who is moving from growth to boom and who is about to go bust!
Ahead of the Curve with Adam O’Dell
Efficient Market Hypothesis Is Bunk
As Rodney says well above, the markets would be brutally booooooring if investors were actually the “rational actors” market theories have assumed they are for many years.