Financial Asset Bubble Spotting Isn’t Hard: But Whose Job Is It?
Stock-Markets / Stock Market Valuations Nov 13, 2009 - 04:10 PMBy: Andrew_Butter
There is no dispute about what happened in USA over the past few years:
1: There was a Tech Bubble – It popped (that caused economic damage).
2: There was a Housing Bubble – It popped (that caused economic damage)
If you go with my definition of what a bubble is:
When market participants lose sight of fundamental value and pay too much – much too much for things, until they all realise they paid too much, after which prices go down and they can’t sell what it was they paid too much for, sometimes for even half the price they paid in the first place, so either they get wiped out or the banks that lent them the money get wiped out.
And that’s zero sum, it just transfers money mainly to rich people (who got in and out early), from poor people (who got in late and out late); less of course “efficiency losses” (the fees that the banking system made out of the “party”).
Then as part of (2):
3: There was a bubble in mortgaged backed securities (people who bought AAA RMBS in 2008 would be lucky to get 50 Cents on the dollar now unless the Fed wasn’t propping the market up).
I.e. the bubble popped (that caused economic damage).
Then as a contributing factor to (3) people like AIG sold insurance on those RMBS (and other debt would not default) far too cheap, and racked up $68 trillion of potential liabilities on that, which might have unravelled if Father Christmas hadn’t turned up to pay Goldman Sachs 100 cents on the dollar.
Now the Fed is lending firms like Goldman Sachs money at 0% interest rates so they can lend it (back) to the Treasury at 3.5% and “earn” their way out of trouble. That is causing economic damage.
Did I miss something?
Alan Greenspan famously said that (a) “if the market can’t spot a bubble then how could the regulator?” And (b) “it’s impossible to know that you are in a bubble when you are in one”.
Yet we hear now from Frederic Mishkin that although he can’t apparently spot a bubble (he certainly couldn’t in Iceland), he can certainly tell a good one from a bad one (http://seekingalpha.com/.. ).
That’s comforting, particularly after Alan Greenspan (who Mishkin presumably idolizes) admitted in so many words that he didn’t have a clue what he was doing for eighteen years, or that is at least the message that I got from the transcript of his public humiliation:
(http://www.marketoracle.co.uk/financial_markets_analysis_videos.htm ):
Republican Henry Waxman asked a question: “You have been a staunch advocate for letting markets regulate themselves, and my
question for you is simple; were you wrong?”
Greenspan: “Yes, I found a flaw and…but I’ve been very distressed by that fact”.
Waxman: “You found a flaw in the reality…”
Greenspan: “A flaw in the market that I perceived was the critical function and structure that defines how the world works, so to speak”.
Waxman: “In other words you found your view of the world, your ideology was not right”.
Greenspan: “Precisely! That’s precisely the reason that I was shocked because I’d been going for forty years or more with very considerable evidence that it was working exceptionally well”.
As usual with Alan Greenspan it’s impossible to clearly understand what he was saying, although he did apparently admit that he was wrong (so to speak).
Here’s a notion:
1: Perhaps he was wrong about not being able to spot a bubble, perhaps just he couldn’t do that?
2: If the Fed and other regulators implicitly and explicitly controlled by the Fed are responsible for helping create the bubble(s) in the first place, perhaps they might be persuaded to TRY HARNER when it comes to spotting bubbles?
3: Perhaps if bubbles are such a potential source of economic damage it might be a good idea to put someone in the job, who at least claims that he has got some idea about how to spot them?
Fire-fighting
When Secretary Geither presented the Great New Plan for Financial Reform in March 2009, he was on a roll, when someone challenged him about increasing the power to the Fed (the question included something along the lines of “isn’t that a bit like buying your teenager a sports car after he just wreaked the family saloon), he responded:
You can’t fight a fire with a committee.
But why is the focus of Financial Reform on “fighting fires”?
Ever heard of Fire Regulations?
They are six inches thick and they are all about preventing fires!!
Fighting fires, well anything goes, a fire-fighter has carte blanche to break down doors, climb through windows, spray tons of water all over the place, and selectively save the maidens (Goldman Sachs) and leave the dogs behind to burn (Lehman).
What’s new?
Perhaps if someone had recognised that the bubble that started in stocks in 1996 and the bubble that started in housing in 2000 were bubbles, and had done something about it (George Soros’ sensible suggestion was to get the SEC to limit new IPO’s to contain the Tech bubble, and to limit the amount of liquidity that went into the housing market (like central banks used to do), would have worked, (as would have putting an increasing cap on the LTV of mortgages).
So “putting out the fire” BEFORE it burnt the whole city down would have been quite easy to do, if (a) someone who gave a damn had been bothered to think for ten seconds whether there was a bubble forming or not and (b) had been bothered to do something about it.
That comes back to spotting bubbles:
Talking about stocks, there are three recognized “valuation” approaches to figuring out what is sometimes called “Fair Value” of the stock market.
If I may I would like to use the word “Equilibrium Value” because “Fair Value” means one thing to investment gurus, and something completely different to accountants, and something completely different again to valuation professionals.
The three methods are:
1: P/E rations as per Professor Shiller, this is some sort of approximation of an income capitalization valuation that attempts to discount future earnings based on historical earnings.
2: Tobin’s “q” which is a methodology of calculating replacement costs.
3: Warren Buffet’s method which looks at GNP and stock market capitalization which is in effect some approximation of an income capitalization methodology also.
I’m not going to argue the toss about which is right or wrong or more right or more wrong or why, except to look at the recent track record of these three approaches:
>> In January 2009 Andrew Smithers published a report based on an analysis of “q” saying “the US (stock market) is relatively expensive, being around Fair Value” and “We remain bearish about the outlook for equities for 2009”.
>>At the same time CLSA strategist Russell Napier was saying 400 was “Fair Value”.
>>Warren Buffet had declared that October 16th 2008 was about the bottom and he was “greedily” buying when everyone else was paralysed with fear, (that was when the index was 950 or thereabouts. So he obviously thought that “Fair Value” was 950 or more.
>>On the other end of the spectrum Jeremy Grantham a proponent of the P/E Ratio was predicting a bottom “below 600” although he didn’t say what “Fair Value” was.
>> On 23rd February 2009 Professor Shiller said that US Stocks were “Fair Value”, (the S&P 500 was 754) but he warned they could “overshoot, by as much as 40%”.
>>In June 2009 The Business Insider’s Henry Blodget reported, “Now, with stocks having surged some 35% in the past three-plus months (up to 939), the broader market is back up to “Fair Value” levels according to the Shiller P/E”.
Clearly there is a range of values depending on your Church, and even members of the same congregation apparently don’t always agree with each other.
Incidentally Nadeem Walayat (http://www.marketoracle.co.uk/UserInfo-Nadeem_Walayat.html ) who uses a melange of valuation approaches including Elliott Waves predicted the bottom of the Dow at 6,600, but he doesn’t do valuations so I’m not considering his work here (also most Elliott Wave theorists get a different answer from him).
International Valuation Standards
There is another way of doing valuations which is not very popular with stock-pickers although the standards have been in place since 2000 (and they took about ten years to write). One advantage about those standards is that they are approved by every valuation institute of any consequence in the world, although sadly almost no one uses them. They are called international Valuation Standards (IVS).
However, they are a valuation standard, so just for fun (I do valuations so for me that’s fun), I applied IVS to do a valuation of the US stock market and then applied the logic of BubbleOmics ( http://www.marketoracle.co.uk/Article12114.html ).
The outcome of that analysis was:
1: Jan 2009: The S&P 500 will bottom at 675.
2: Feb 2009: Then it will rally strongly.
3: May 2009: The rally will go on at least until the Dow hits 10,000.
It would appear that although using IVS to do a valuation of stock markets is “unconventional”, it does appear to come up with the right answer (note those are the only valuations that I am aware of that have been done of the US stock market using IVS).
But that’s all bye the bye, although for that reason I have compared the FOUR approaches to valuation.
Well apart from the fact that each of the four approaches disagrees on the detail (in my opinion for example the mis-pricing of the stock market in 1929 was much worse than in 2000), big picture they all agree, for example:
1: A regulator might profitably have done something about a “bubble” starting in about 1923.
2: He might profitably have woken up from his slumber in 1965.
3: And again he might have roused himself in about 1996.
That doesn’t sound like an excessive workload, and it really wouldn’t have mattered which methodology he went with (he could have taken an average), he would still have (a) spotted a bubble (b) in time to do something about it.
There is a similar chart on house prices (only IVS and Shiller), both clearly say that in 2000 if something had been done, the house price bubble could have been avoided.
Conclusion:
1: It is not impossible to recognize a bubble.
2: It’s not hard to do something about one when you can “see” one.
3: Why on earth do the new Financial Reforms say nothing about doing that?
By Andrew Butter
Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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