Pricking Bubbles 101

Name of module:		Pricking bubbles 101
Course requirements:		Growing Bubbles 101 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 sit on the Securities Exchange Commission or similar regulatory bodies

 

 

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Lecture 1		Of Bubbles
Introduction:		Market bubbles

Market bubbles develop when a bull market lasts too long.

Bull markets are a good thing. They are good for the economy and for investors and for Politicians. Bubbles are bull markets with an immortality complex. Initially they are very good for investors and even better for Politicians, but not so good for the economy. In a bubble all kinds of imbalances develop that might be good subject material for speeches by Important People, but sooner or later these imbalances are really 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, now 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 to refresh their memories of how bubbles are cultivated.

Briefly, there seems to be a business cycle of growth and recession that is also evident in the stock market. The stock market is on the one hand an important cylinder in the engine of the economy and on the other hand also acts as its barometer.

There are highly astute people in various Government agencies and organisations who are charged, openly or covertly, with the task of keeping the national currency healthy, which is often also interpreted as keeping the economy growing steadily, as that is perceived as a prerequisite for a healthy 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, only to be followed by a declining phase that lasts from say 18 months to about 3 years.

A major reason for the business cycle is found in consumer debt. When the economy begins to bloom, consumers make new debt at a faster rate than the growth in their incomes. This rapid increase in debt at first helps to fuel the expanding economy and is therefore encouraged by a lax monetary policy, low rates and easy credit.

The next step in the cycle is when production lags growth in demand and prices start to rise faster. Inflation sets in and authorities are forced raise 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.

It follows that for a bull market to extend longer than its natural time span, it has to be actively nurtured and coddled by the authorities. There are two requirements for this to happen, apart from political rhetoric – 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. Foreign inflows of funds provide the liquidity to keep the credit bubble growing without pain to consumer (often called 'sheeple', but this term should strictly be used only for consumers who are also active traders in equities).

Cheap imports contribute to the inflow of funds and help to keep inflation low, while the threat of foreign competition keeps the local workers from asking for wage increases.

It is of course axiomatic that if a lot of funds come into the country and then flow from the banking system into the pockets of consumers in the form of easy credit, a good fraction of the money will find their way into the stock market keeping the bull alive and adding to the.

Unfortunately, the political advantages of a flourishing bull market are put at risk when the bull lasts long enough to transform itself into a bubble – 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 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 and on estimates of future growth in the new market that is opened up by that technology that investors find irresistible. As time passes, the group of popular stocks diminish in size and the pursuit of the few remaining favourites become more frenzied. PE's reach impressive numbers and these are justified by even more optimistic estimates of the size of the future market.

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, the analyses are inherently flawed. Given anywhere realistic assumptions of the future size of the market, calculations will show that the current high PE's of the say 15 companies in one market segment are predicated on each of them obtaining 35% or more of their potential market.

Given the existence of this flaw, it is in the nature of bubbles to end quite soon, as time in markets is measured. When they do, it does not take place slowly like a tire deflating, but more like a over-blown balloon that believed itself to be pin-proof. 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 – very much in tatters.

So too, of course, does the financial condition of most households.

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 101.

The objectives of the module

Bubbles are robust, up to a point. A bubble doesn't jump around and shout, "Look at me! I'm a market bubble!" A bubble masquerades as a beautiful and long lasting bull market, a sign of the effects that the new technology of the day will have on the 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 measures to value the companies at the forefront of the new technology.

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 that railroads, the automobile and radio, computers and electronics, and more recently the internet.

Once the façade of the bull market starts to crumble to reveal the fragility of the actual bubble behind it, most often under a sustained assault from increasing interest rates, the end and final collapse can be abrupt, steep and 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

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 engineers.

Rule 1: Keep the purse strings loose
A primary cause of the bubble was a lax monetary policy. The most important rule for this engineering process is to keep pumping cash into the system. The more that use can be made of changing circumstances in the economy to justify the high growth in the money supply in order to conceal the true motive, the better. And the greater the chances for re-election of the governing party, who can point out with pride how well they have managed the economy and how rich the voters have become.

If at any time an approaching pin is spotted on the horizon, it is essential 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.

The latter objective is also achieved by warning them repeatedly of imbalances between supply and demand and the risk that shortages arising from the inability of the manufacturing sector to deliver will lead to higher prices soon. What better reason to rush out and buy right now! On credit of course.

The first reaction from the consumer to such a message is likely to be a visit to the bank manager followed by a quick trip down to the local auto dealer or the marina where that pretty little boat is up for sale, or to the interior decorator or the hi-fi shop for that new TV-cum-home entertainment console. Or to buy a faster computer with which to visit all the sites on the internet 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. One should keep in mind that throughout the bull market and the bubble that followed, the 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 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 a just a brief moment of 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 holiday, rather than to make new debt for this purpose. A wave of selling is the last thing the Bubble wants.

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 that 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. Even 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 now win the election will not be happy, since it will require more time than their term in office to put 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 bad form to bite the hand that feeds you.