January 7th, 2015

Errors in Bubble Analyses

I don't understand why people make this mistake. I noticed it about ten years ago when Krugman made it with respect to the housing bubble.

http://www.nytimes.com/2005/08/08/opinion/08krugman.html?_r=0

"In Flatland, which occupies the middle of the country, it's easy to build houses. When the demand for houses rises, Flatland metropolitan areas, which don't really have traditional downtowns, just sprawl some more. As a result, housing prices are basically determined by the cost of construction. In Flatland, a housing bubble can't even get started."

The error here should be obvious, but apparently is not. Bubbles can manifest in the form of very high prices (the spike a result of price insensitivity in the context of inelastic supply). But they can also manifest in the form of oversupply (the spike here occurs as a result of a delay between when demand is communicated to producers and when producers actually put the supply on the market).

Got it? Okay. Here's where I saw the error today.

http://www.businessinsider.com/robert-shiller-doesnt-think-bonds-are-in-a-bubble-2015-1

"In an interview with Time Magazine, Shiller said of the current low yield environment: “It doesn’t clearly fit my definition of ‘bubble. It doesn’t seem to be enthusiastic. It doesn’t seem to be built on expectations of rapid increases in bond prices.”"

The bubble in bonds is the expectations of a certain group of Boomers who think of themselves as careful, prudent people, and whose entire adult investing career has been built on bonds, munis, bond funds, etc., over the course of a 30-40 year bull market in bonds. The expectation is that by being careful and prudent and buying bonds, their investments will take care of them throughout their retirement.

You can tell a bubble _after_ it has popped, because you have a bunch of stunned holders who would like to sell something that they paid X for, and people won't even given them 10c on the dollar for it, if they can find a buyer at any price at all. And that is what is going to happen to holders of 5, 7, 10, etc. 30 year notes when, over the next few years, rates normalize and no one wants what they are holding any more.

We can all argue about whether it was overissuance of debt at low interest rates (Flatland) or paying too much (too low an interest rate on the notes -- paying too much for your house in the Zoned Zone, in the Krugman story) later on. But we'll know when it pops, because all those Boomers are going to be outraged.

ETA: Here's a Bloomberg take on it:

http://www.bloomberg.com/news/2014-09-22/tiger-s-robertson-says-bond-bubble-will-end-in-very-bad-way-.html

Of course any company that has any debt at all at this point (and many, many, many homeowners) has refinanced their debt to take advantage of these super low rates. That would be the "overissuance" argument. I'm inclined to suspect that this is fundamentally why it is so hard to perceive this particular bubble, altho there's a lot of Cry Wolf going on, too. Financial advisors have been swearing that the bull market in bonds is just about over for my entire investing career (granted, not that long -- I dimly recall buying some zeroes around 1997 or 1998 and being warned about it then). I'm young yet, but if I were a decade or so older and mostly innumerate, and I'd been hearing people tell me the bull market in bonds was over for a decade and a half plus, I'd just laugh at the prediction.