Saturday, June 15, 2013

You - Creator of All Financial Bubbles

You are the reason why we have bubbles. Stop blaming others and face the reality. Don't believe me? Answer this question: if you knew that a company will go bankrupt soon, how much would you pay for its stock?
Screenshot image of YouTube's web page where the documentary describing some of Vernon Smith's experimental economics work is hosted.
Launch Bubble Experiment Video
Based on the studies that earned Vernon Smith his Nobel Price in economics, if you are human, you would be a creator of bubble. You would drive the price of an asset that will soon become worthless to a unsustainable level until it inevitably collapses.
Since the eighties, Mr. Smith has been conducting experiments that reliably created nice and frothy financial bubbles no matter who was behind the buy button. It seems that when you ask people to make money, everybody has it within themselves to be able to turn into an unmentionable, like a Wall Street banker or worse. I suggest that you check the short video describing one of these tests. Seeing Mr. Smith's experiments has changed my views about bubbles. I am convinced that we will continue to create them.
Right now, a bubble in bonds is ready to pop any day. But since almost no one understands bonds, it will probably be misrepresented. Bonds are the kind of economics stuff that makes people's eyes glace.
What will surely get lots of airtime are the effects from the blow up. Whether we know it or not, bonds affect everything. Interest rates and borrowing are tied to the bond markets. Bonds also affect cash-flowing assets like real estate and dividend paying stocks.
Photo of white balloon on black background. The balloon has a line drawing image of an asset price graph showing a boom and bust cycle
Bond Bubble
In a previous post, I covered the current state of the housing market and the many distortions taking place. Benjamin Graham, the father of value investing, once said "in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine". This phrase too applies to the real estate market. In the short run, the market is distorted. The Fed's push for liquidity plus a surplus of global savings create a tidal wave of funds seeking a place to land. As the Federal Reserve's Quantitative Easing program crowds these funds out of Treasury Bonds, the inevitable result is that way too much risk-adverse capital is being deployed by companies like Blackstone to drive prices of the wrong type of assets. Assets that would be much more stable when fueled by patient capital from home buyers instead. Even builders have noticed the distortion. Lumber prices are way down, as a sign that things are not peachy on the housing supply side.
Real estate does not have to be in a bubble for home prices to come down sharply. As long as bond values collapse, real estate will correct to the point of long term balance. Even Robert Shiller, the greatest authority in real estate and the creator of the S&P Case-Shiller Index, has been warning that a real estate bottom has not been reached yet. He is clearly skeptical of the sustainability of the present rise in the housing index that he created.
Just 13 years ago, we saw the collapse of the Tech Bubble. Then, in 2008, we all played the game once again. We witnessed the implosion of the financial derivatives and real estate bubbles. To prevent these bubbles from happening, many have called for more government oversight and more regulations. Yet existing regulations proved inadequate. Meanwhile, bigger regulators and the structural rigidity from extensive regulations do create a lethargic-bureaucracy where progress is slow and innovation is absent.
Photo composition of small boat floating over the ocean with a piano and stool falling off the sky. There is the legend: "Murphy's Law" "If it can go Wrong, it will !"
Theory of Constraints
That regulations do not solve the problems should be readily understood by those with a basic knowledge of Eliyahu Goldratt's Theory of Constraints. Knowing with certainty that Murphy's Law will occur does not give any indication of where it will happen. Likewise, knowing that bubbles will happen does not mean that we know where to place the right regulation. A bubble will simply pop elsewhere. This is a fundamental fact known by operations experts all around the world. As a business manager, if you are not abreast of the wealth of knowledge that now forms the core of practices like Six Sigma and LEAN, you are absolutely and without a doubt doing a disservice to your company, family and society. The Toyota Way, which is part of what created this fantastic operations movement, has instituted effective methods to successfully deal with constraints of varying nature, such as those addressed by Mr. Goldratt.
Logo image of, the government's wiki site where they intend to gain help from the people on new regulations to create.
Regulations-happy Nation
Incredibly, our politicians and the public seem to be perpetually engaged in a fruitless merry-go-round as they hold hope that regulations can be effective. Inexperienced warehouse managers fall on the same traps. Thankfully, the answers are ready and available to those who take the time to invest in a little bit of knowledge. Simply put, no amount of regulations will prevent constraints (or bubbles) from happening.
In conclusion, the evidence suggests that, like Murphy's Law, bubbles will happen. Perhaps it is time for the bond bubble to pop next. But Rather than placing blame, we should admit that bubbles are within us all. There is good scientific proof supporting this belief. We should also understanding that regulations will fail to prevent bubbles because of difficulties anticipating where to place such regulations. On the other hand, and since bubbles are created by incentives, we should look at incentives as a way to prevent bubbles. Maybe there is a lesson within operational practices at places like Toyota after all.

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