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Saturday, August 16, 2014

Improving Economies Should Avoid Destructive Bubbles



Citi Analyst Rob Buckland published a diagram of the potential bubbles that are brewing in the credit and equities market. He sees markets moving into Phase 3 where unhealthy optimism is taking hold and people are failing to adjust to early signs of bubbles. If we continue to our course without adjusting and understanding where these bubbles are they will grow and potentially burst forcing the economy to reverse course. You may see his chart HERE. The phases are: 

Phase 1: End of recession, interest is low and stocks are low. 

Phase 2: Stocks rise in a bull market and credit speeds economic activity.

Phase 3: Stocks are high, credit risks hedge, unhealthy optimism in stocks, early signs of bubbles show. 

Phase 4: Low credit reverses value of stocks, credit and equities fall, lower company profits that cause a recession. 

Economic bubbles are part of the boom and bust cycle of the economy. Economics define a bubble as an asset that’s prices can no longer be justified by the value of the dividends expect to earn (Barlevy, 2007). People pile their investment monies into the bubble with high expectations raising the price beyond its real value. 

Real value being based on its practical utility, costs, and additive value associated with the product itself. This is different from the perceived value as defined by market interest. A house may have a certain real value as a dwelling of construction materials but may be sold at double or triple that value due to easy credit and market interest. If people decide the cost of purchase is no longer worth it to them the value plummets and investors lose money. 

On a wide scale this could impact markets in a heavy way across a broad range of economic sectors. We only need to view the last recession and how homes were sold beyond the value that any reasonable person would be willing to pay for them causing debt to skyrocket. Irrationality was the mainstay of the day as broad sectors of society were buying and pushing the price upwards with little consideration of its true value. 

Bubbles can be found and predicted with logistic functions and models that help see the change in irrational value (Ekonominiu, et. al., 2009).  Many of these models are based on statistical analysis that predicts that irrational value increase are beyond the inherent value of the product. They can use various market indicators in associated sectors to determine one sector’s value is out of place.

At present there is no perfect way to predict a bubble but it is possible to be forewarned of a bust whenever irrational optimism has taken hold, critical thinking of investors is low, and investment capital is piling into a market sector that hasn’t seen substantial infrastructure and technological improvements to support the increased value. The best hedge against bubbles is to diversify a portion of your capital into unrelated sectors that counter market direction when busts occur.

 Barlevy, G. (2007). Economic theory and asset bubbles. Economic Perspectives, 31 (3). 

 Ekonominiu, B. et. al. (2009). Formation of economic bubbles: causes and possible preventions. Technological & Economic Development of Economy, 15 (2).

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