Why asset bubbles are inevitable

Discussion in 'Trading' started by garfangle, May 6, 2010.

  1. Despite enduring two of the largest asset bubbles within a decade (the tech bubble and housing bubble) we will continue to have more bubbles because of our psychology that almost always believes that rising prices for assets are a good thing (even though we know it is not true). This is because many investments have converted their returns from dividend payouts to speculative capital gains. Because investors need capital appreciation to earn any decent return, we are more likely to invest by chasing momentum which leads to inevitable booms and busts.

    Investing has gone away from the advice of asset accumulation to asset appreciation. Accumulation means you own more of something. Appreciation means you own something at a higher price. Those are two distinct strategies and follow two different paths of investing.

    When you buy an asset (stock, commodity, real estate) where the principle investment gain is through capital appreciation you must hope for ever increasing prices to receive a return on your investment (Who I will call Appreciators). This is in contrast to assets whose primary returns are derived from dividend income which can be reinvested and accumulate more shares or property (Who I will call Accumulators).

    Therefore, if you hold an asset that relies on capital gains you do not care if the price becomes untethered to its historic valuation, by which I mean expanding earning multiples. In fact, you want multiple expansion because when sell you achieve a richer price than if the multiple didn't grow. Unfortunately, the person who bought it from you must sell it to someone else at a higher price still. Of course, multiple expansion is the bane of income producing investments because you receive a lower dividend yield. Here, you want multiple contraction, meaning lower asset prices.

    The two strategies lead to two different mindsets when prices rise and fall. When prices rise 1) Appreciators chase the price increase lest they lose their opportunity to buy it at that then lower price (The "buy now or be shut out forever" phenomena); 2) Accumulators see falling yields and either cut back or decline to invest further. When prices fall 1) Appreciators see fewer people willing to buy and sell in a panic if they find themselves deeply underwater because there is no guarantee they will be able to return to breakeven; 2) Accumulators see rising yields and are willing to buy because their investments' dividend payouts can be reinvested at those higher yields.

    What you wind up with are one type of investors, the Appreciators, who chase momentum and panic sell, meaning buy high, sell low and another type of investors, the Accumulators, who take advantage of price fluctuations to buy low and sell high. The former foment bubbles and the latter ameliorate them.

    Bubbles form when multiples expand and busts follow when multiples contract. To reduce the likelihood of a boom/bust cycle investors need to rethink their love of ever increasing prices and switch to investments that rely on income to produce the bulk of their returns.
  2. businessstaxes

    businessstaxes Guest

    there was no tech bubble in 2000,,it was pump and dump scam.

    there was no real estate bubble,,it was scam to sell worthless CDO to orphans, widowers,pensions

    yes, it was not conspiracy but planned to sell worthless stocks and CDO bonds to the public by Goldman Sachs.

    huge profit is selling something that is worthless.

  3. Kubinec


    How about instead abolishing the Central Banks that set the soil for the bubbles to form by fixing the interest rate? You know, actually having a sound monetary policy? Ever thought of that? One of life's fundamental truths is cause and effect. What you're advising is to focus on the effect, rather than the cause. The symptoms, rather than the source of the disease.
  4. From wiki.

    The Fed's pattern of providing ample liquidity resulted in the investor perception of put protection on asset prices. Investors increasingly believed that when things go bad, the Fed would step in and inject liquidity until the problem got better. Invariably, the Fed did so each time, and the perception became firmly embedded in asset pricing in the form of higher valuation, narrower credit spreads, and excess risk taking.[1] It has been criticized[by whom?] as a form of privatizing profits and socializing losses, and as inflating a speculative bubble in the lead-up to the 2008 financial crisis.

    The "Greenspan Put" refers to the monetary policy that Alan Greenspan, the former Chairman of the United States Federal Reserve Board, and the Fed members fostered from the late 1980s to the middle of 2000.

    "Put" refers to a put option in which the buyer acquires the right to sell at a pre-agreed price if prices drop. During this period, when a crisis arose, the Fed came to the rescue by significantly lowering the Fed Funds rate, often resulting in a negative real yield. In essence, the Fed pumped liquidity back into the market to avert further deterioration.

    The Fed did so after the 1987 stock market crash, the Gulf War, the Mexican crisis, the Asian crisis, the LTCM debacle, Y2K, the burst of the internet bubble, and the 9/11 attacks.

    Stay tuned for the Bernanke put
  5. ptrjon


    sorry, wrong. the initial expansion of the internet was an incredible change to the way the people of the world lived, and it was hard to gauge just how big it would get. I believe that now we are seeing some of the hopes of the .com boom come to life.

    The real estate boom happened because the aggregate demand for houses was manipulated. Legislation making it possible for "everyone to own a home" and fancy mortgage products, paired with the original poster's notes on irrational buying, caused the housing crisis.

    I enjoyed reading the original post, and completely agree with it. nice job.
  6. There were asset bubbles before central banks came into play, so this argument doesn't hold.
  7. ptrjon


    well, central banks add to the likelihood and scope of bubbles. When things are bad, they flood the market with cash. When things are good, there are too many pressures against raising rates and lowing liquidity- so they tend to let the loose money slosh around and creat bubbles.