The Road to Revulsion
I will add the text in full. It is quite long. In a future post, I’ll give you my thoughts on bubbles and how to prevent them. Expect something along the lines of Mises or Rothbard from the Austrian School. A preview of my own thoughts on bubbles can be found in the post, “The U.S. Economy 2008.”
Montier is one of my favorite economic commentators. His pieces are always thought provoking. I intend to recycle another of his posts called “Scepticism is rare” in a future blog entry.
The Road To Revulsion
by James Montier
A couple of months ago I wrote a note arguing that events unfolding the in the U.S. weren’t a black swan but rather an example of a predictable surprise (see Mind Matters, 13 March 2008 http://sgresearch.socgen.com/publication/strategy_periodical(20080313)_408.pdf). To claim the credit crisis as a black swan is to abdicate all responsibility for its occurrence. I argued that bubbles are a by-product of human behaviour, and that human behaviour is sadly all too predictable.
The details of each bubble are different but the general patterns remain very similar. As Marx said, history repeats itself, the first time as tragedy, the second time as farce. It is the general pattern of debubbling that I wish to explore this week, particularly in the context of the market’s apparent attitude that the worst of the problems seem to be behind us.
Bubbles: a framework for analysis
We have long been proponents of the Kindleberger/Minsky framework for analysing bubbles (see Chapters 38 and 39 of Behavioural Investing for all the details). Essentially this model breaks a bubble’s rise and fall into five phases as shown below.
Displacement – The birth of a boom
Displacement is generally an exogenous shock that triggers the creation of profit opportunities in some sectors, while closing down profit availability in other sectors. As long as the opportunities created are greater than those that get shut down, investment and production will pick up to exploit these new opportunities. Investment in both financial and physical assets is likely to occur. Effectively we are witnessing the birth of a boom.
Credit creation – The nurturing of a bubble
Just as fire can’t grow without oxygen, so a boom needs liquidity to feed on. Minsky argued that monetary expansion and credit creation are largely endogenous to the system. That is to say, not only can money be created by existing banks but also by the formation of new banks, the development of new credit instruments and the expansion of personal credit outside the banking system.
Everyone starts to buy into the new era. Prices are seen as only capable of ever going up. Traditional valuation standards are abandoned, and new measures are introduced to justify the current price. A wave of overoptimism and overconfidence is unleashed, leading people to overestimate the gains, underestimate the risks and generally think they can control the situation.
Critical stage/Financial distress
The critical stage is often characterised by insiders cashing out, and is rapidly followed by financial distress, in which the excess leverage that has been built up during the boom becomes a major problem. Fraud also often emerges during this stage of the bubble’s life.
This is the final stage of a bubble’s life cycle. Investors are so scarred by the events in which they participated that they can no longer bring themselves to participate in the market at all.
Bull traps in bear markets
Of course, no debubbling process occurs in a straight line. They are punctuated by electrifying bull runs than end up as bear traps. I first came across the wonderful chart below in Marc Faber’s Doom, Boom and Gloom report. It struck such a cord that I had to reproduce it here, taken from Colin Seymour’s website.
The comments made every time the market rallies are characterised by the ever-present optimism that we have discussed many times. I suspect that is exactly what we are witnessing currently.
The first wave of concerns created by the bursting the housing/credit bubble (and make no mistake they are two sides of the same coin) is subsiding. The optimists believe (or at least hope) that the worst is now over. Indeed the probability of a recession in 2008 has dropped to 39% on the Intrade contract!
However, from our perspective such sanguinity is likely to be misplaced. The slowdown in the U.S. is barely starting. The charts below show that both the demand and supply for .credit. are evaporating. This effective shutdown of both sides of the market should be a serious concern for monetary policy makers, as it is one of the hallmarks of a liquidity trap situation.
Note in particular how widespread the lack of demand for credit is, as well as the supply! This isn’t just about the housing market. Obviously demand for mortgages (both commercial and residential) is lacking, but so is the demand for consumer credit, and corporate credit. This doesn’t bode well for the outlook.
The underlying asset adjustment is likely to have much further to run as well. The chart below shows the developments in U.S. house prices and Japanese land prices during their bubble and burst. The point of this chart isn’t to say that U.S. prices will follow Japanese prices, but rather to illustrate the long drawn out nature of the healing that has to occur. Indeed, one client recently asked me if this was worse than the S&L crisis. To my mind it is much worse, as securitisation was part of the solution to the S&L problems, whereas it has been part of the problem in the build-up in this bubble.
Indeed, one of the lessons that should be learnt from the Japanese experience is that the banks were second round losers, a point made by Albert Edwards recently (see 3 April http://sgresearch.socgen.com/publication/strategy_update(20080403)_cc0.pdf Global Strategy Weekly). They didn’t really begin to underperform the rest of the market until the second Japanese recession of its debubbling process. They really started to suffer when their consumers (Japan Inc) started to struggle.
From a market perspective, financials remain an exceptionally large component of the market itself. As the chart below shows, today’s 17% of market cap may be well off the high of nearly 25% but remains a long way above the levels before this bubble started.
One of the other lessons of importance from Japan is that it is never the stocks that led you into the bubble that lead you out. For instance, in Japan’s post bubble environment it was the capital-starved autos and electricals that were the winners. Just as the U.S. market recovery after the dot com bubble wasn’t led by tech but by mining, material and financials. Those deprived of capital do best in the aftermath of a bursting bubble, not those gorged on it. This argues that it isn’t likely to be financials that lead us into any sustained rally.
This makes it all the harder to understand the way in which investors have been cheering the rights issues/capital raisings that financial firms have been carrying out. I recently described investors. responses to rights issues as the investment equivalent of being mugged and then turning around and saying thank you to the perpetrator (and perhaps offering to take them to the cash point and get some more money out for them).
The chart below may just give some pause for thought. It comes from a study by Capstaff et al1. They study the long-term performance of stocks conducting rights issues in the UK between 1986 and 1995. In particular, they split out the evidence in the pre 1991 and post 1991 periods. This is interesting because it reveals two different motives for a right issue. During the first period, it appears managers issued more equity to take advantage of high valuations. However, the second period reflects a more separate need for cash brought on by the last UK housing recession.
Regardless of the motive, the outcome is clear from even a cursory glance at the chart below. Rights issues are bad news for investors. The poor performance of firms conducting rights issues prior to the issue itself is clearly observable for the 1991-1995 sub-period. Even more noticeable is the increased underperformance once the rights issue is over. If history is any guide, investors cheering such issues now are likely to end up severely disappointed at the end of the day.
From our perspective, the market is enjoying a sucker’s rally. The road to revulsion is likely to witness many such events, but the recession reality is only just unfolding. Far from being behind us, the worst may still be ahead!