I recently talked to Dr. Jean-Paul Rodrigue, from the Department of Economics & Geography at Hofstra University to discuss his research on business cycles and how it applies to our current economic situation. His work charted the phases of a bubble, based on hundreds of years of economic data. Thanks to Dave in Calgary for bringing Dr. Rodrigue’s work to my attention. Below is the chart and descriptions of the four phases.
Those who understand the new fundamentals realize an emerging opportunity for substantial future appreciation, but at a substantial risk since their assumptions are so far unproven. So the “smart money” gets in, often quietly and cautiously. This category of investor tends to have better access to information and a higher capacity to understand it. Prices gradually increase, but often completely unnoticed by the general population. Larger and larger positions are established as the smart money start to better understand that the fundamentals are well grounded and that this asset is likely to experience significant future valuations.
Many investors start to realize the momentum, bringing additional money in and pushing prices higher. There can be a short-lived sell off phase taking place as a few investors cash in their first profits (there could also be several sell off phases, each beginning at an higher level than the previous one). The smart money takes this opportunity to reinforce its existing positions. In the later stages of this phase the media starts to notice and those getting in are increasingly “unsophisticated”.
Everyone is noticing that prices are going up and the public jumps in for this “investment opportunity of a lifetime”. The expectation of future appreciation becomes a “no brainer” and a linear inference mentality sets in; future prices are a “guaranteed” extrapolation of past price appreciation, which of course goes against any conventional wisdom. This phase is however not about logic. Floods of money come in creating even greater expectations and pushing prices to stratospheric levels. The higher the price, the more investments pour in. Fairly unnoticed from the general public caught in this new frenzy, the smart money as well as many institutional investors are quietly pulling out and selling their assets to eager future bag holders. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep the appreciation – “the game” – going. The market gradually becomes more exuberant as “paper fortunes” are made and greed sets in. Everyone tries to jump in and new investors have absolutely no understanding of the market, its dynamic and fundamentals. Prices are simply bid up with all financial means possible, particularly leverage and debt. If the bubble is linked with lax sources of credit, then it will endure far longer than many observers would expect. At some point statements are made about entirely new fundamentals implying that a “permanent high plateau” has been reached to justify future price increases; the bubble is about to collapse.
Blow off Phase
A moment of epiphany (a trigger) arrives and everyone roughly at the same time realize that the situation has changed (like the Road Runner Coyote realizing he is about to fall after walking on thin air for a few seconds). Confidence and expectations encounter a paradigm shift, call it a reality check, not without a phase of denial where many try to reassure the public that this is just a temporary setback and that anyone saying otherwise does not know what he is talking about. Some are fooled, but not for long. Like a directionless herd many try to unload their assets to a greater fool, but takers are few; everyone is expecting further price declines. The house of cards collapses under its own weight and late comers (commonly the general public) are left to hold the bag while the smart money has pulled out a long time ago. Prices plummet at a rate much faster than the one that inflated the bubble. Many over-leveraged bag holders go bankrupt, triggering additional waves of sales. There is even the possibility that the valuation undershoots the long term mean, implying a significant buying opportunity. However, the general public at this point considers this sector as “the worst possible investment one can make in his life”. This is the time when the smart money starts acquiring assets at bargain bottom prices.
I asked Dr. Rodrigue for his opinion on whether the current markets are in the “return to normal” phase or the “return to mean” phase.
My assumption concerning the stock market is that we are in the “return to normal”. It is not because that the contraction is taking place at a slower rate that one should declare that “the recession is over”. There is quite a lot of desperation so the market appears to cling to any news that is not horrible with a positive spin.
The next shoe to drop is linked with the commercial sector that has overinvested and malinvested, fooled by the debt fueled consumption binge that was the real estate bubble (if debt is defined as present consumption at the expense of future consumption, then it can be assumed that there will be much less consumption than expected in the future). You should see the blood bath that is currently taking place in the maritime shipping industry; gigantic capacity coming online at the same time the demand is dropping sharply.
Once the “stimulus” will be spent, both financially and politically, and that people will see it for what it was – a macroeconomic fraud – then there should be a another downside until we reach the “return to the mean phase”. One can also wonder about the unfolding pension crisis as the baby boomer generation enters retirement age with limited savings and depleted assets (real estate and 401k/RSSP). A question I am asking myself these days is how all of this will be defaulted on, particularly defined benefits plans?
Thanks to Dr. Jean-Paul Rodrigue for taking the time to share his thoughts and research with The Canadian Finance Blog. His theroies show a possible outcome for the economy that isn’t being discussed much as stock markets move higher.