Saturday, April 11, 2009

Signs of Bubbles… “Betting on the Market”

PBS’s Frontline did a piece called “Betting on the Market” only 12 short years ago. Today it looks and plays like an important piece of history.

The video below shows Jim Cramer and other fund managers in the momo days of 1996. This is a terrific history lesson in bubbles. The video below is part 1, please view but don’t laugh too hard at how television made over Cramer:

Jim Cramer in 1996. "Betting on the Market" PBS Frontline (1997 Part 1 - 10 minutes):

Wow, what a throwback! Wouldn’t you love to find out the current situation of the carpet laying couple? How many people recognized in 1996 that they were participating in the largest economic bubble ever created by mankind? Notice the one manager who got up in front of the crowd realized that his opulent surroundings and number of people in the audience meant that he was near the end of the cycle. Did you catch that? He had an inkling, but I’ll bet he couldn’t describe the seven stages of a bubble!

So, let’s review Hyman Minsky’s seven bubble stages:
Ludwig Von Mises noted that the size of the bust is commensurate with the size of the boom and it was Hyman Minsky who accurately described the seven bubble stages (the following excerpt is from my book Flight to Financial Freedom – Fasten Your Finances, written during 2005/2006):

The late Hyman Minsky, Ph.D., was a famous economist who taught for Washington University’s Economics department for more than 25 years prior to his death in 1996. He studied recurring instability of markets and developed the idea that there are seven stages in any economic bubble:

Stage One – Disturbance:
Every financial bubble begins with a disturbance. It could be the invention of a new technology, such as the Internet. It may be a shift in laws or economic policy. The creation of ERISA or unexpected reductions of interest rates are examples. No matter what the cause, the outlook changes for one sector of the economy.

Stage Two – Expansion/Prices Start to Increase:
Following the disturbance, prices in that sector start to rise. Initially, the increase is barely noticed. Usually, these higher prices reflect some underlying improvement in fundamentals. As the price increases gain momentum, more people start to notice.

Stage Three – Euphoria/Easy Credit:
Increasing prices do not, by themselves, create a bubble. Every financial bubble needs fuel; cheap and easy credit is, in most cases, that fuel. Without it, there can’t be speculation. Without it, the consequences of the disturbance die down and the sector returns to a normal state within the bounds of “historical” ratios or measurements. When a bubble starts, that sector is inundated by outsiders; people who normally would not be there. Without cheap and easy credit, the outsiders can’t participate.

The rise in cheap and easy credit is often associated with financial innovation. Many times, a new way of financing is developed that does not reflect the risk involved. In 1929, stock prices were propelled into the stratosphere with the ability to trade via a margin account. Housing prices today skyrocketed as interest-only, variable rate, and reverse amortization mortgages emerged as a viable means for financing overpriced real estate purchases. The latest financing strategy is 40, or even 50 year mortgages.

Stage Four – Over-trading/Prices Reach a Peak:
As the effects of cheap and easy credit digs deeper, the market begins to accelerate. Overtrading lifts up volumes and spot shortages emerge. Prices start to zoom, and easy profits are made. This brings in more outsiders, and prices run out of control. This is the point that amateurs, the foolish, the greedy, and the desperate enter the market. Just as a fire is fed by more fuel, a financial bubble needs cheap and easy credit and more outsiders.

Stage Five – Market Reversal/Insider Profit Taking:
Some wise voices will stand up and say that the bubble can no longer continue. They argue that long run fundamentals, the ratios and measurements, defy sound economic practices. In the bubble, these arguments disappear within one over-riding fact – the price is still rising. The voices of the wise are ignored by the greedy who justify the now insane prices with the euphoric claim that the world has fundamentally changed and this new world means higher prices. Then along comes the cruelest lie of them all, “There will most likely be a ‘soft’ landing!”

Stage Five is where the real estate industry is today [2005/2006]. This stage can be cruel, as the very people who shouldn’t be buying are. They are the ones who will be hurt the most. The true professionals have found their ‘greater fool’ and are well on their way to the next ‘hot’ sector, like the transition from real estate to commodities now.Those who did not enter the market are caught in a dilemma. They know that they have missed the beginning of the bubble (gold, silver, and oil today [2005/2006]). They are bombarded daily with stories of easy riches and friends who are amassing great wealth. The strong will not enter at stage five and reconcile themselves to the missed opportunity. The ‘fool’ may even realize that prices can’t keep rising forever… however, they just can’t act on their knowledge. Everything appears safe as long as they quit at least one day before the bubble bursts. The weak provide the final fuel for the fire and eventually get burned late in stage six or seven.

Stage Six – Financial Crisis/Panic:
A bubble requires many people who believe in a bright future, and so long as the euphoria continues, the bubble is sustained. Just as the euphoria takes hold of the outsiders, the insiders remember what’s real. They lose their faith and begin to sneak out the exit. They understand their segment, and they recognize that it has all gone too far. The savvy are long gone, while those who understand the possible outcome begin to slowly cash out. Typically, the insiders try to sneak away unnoticed, and sometimes they get away without notice. Whether the outsiders see the insiders leave or not, insider profit taking signals the beginning of the end (remember who has sold their rental properties?).

Stage seven – Revulsion/Lender of Last Resort:
Sometimes, panic of the insiders infects the outsiders. Other times, it is the end of cheap and easy credit or some unanticipated piece of news. But whatever it is, euphoria is replaced with revulsion. The building is on fire and everyone starts to run for the door. Outsiders start to sell, but there are no buyers. Panic sets in, prices start to tumble downwards, credit dries up, and losses start to accumulate.

This is where you may see the “lender of last resort” who is usually the government. The government, although they were talking up a soft landing, are now forced to step in to prevent the crises from spreading to other sectors. Ironically, this is where the savvy investor who profited before, really profits now. With government backing, they are asked to step in and return “normalcy” to a now damaged sector.

The government’s attempt to “put out the fire” usually works. However, the conditions beyond the year 2010 will require oceans of water that the government does not posses. You must be ready!

"Betting on the Market" PBS Frontline (Part 2 - 10 minutes):

Mutual funds everywhere. Everyone was invested. You couldn’t lose money, all you can do is make it – it was just a matter of how much. If you weren’t in aggressive growth earning 60% you were a loser! ERISA laws created 401k’s and IRA’s and allowed the common man to “invest” for their retirement with tax deferred savings.

Now mutual funds are so passé.

And what has the same rage today? How about ETFs? Exchange Traded Funds are popping up like weeds. There’s even an ETF that goes up depending upon how many times Nate goes to the bathroom! Look for the 4X inverse next week.

And it’s wonderful because now Joe sixpack carpet layer can invest all his money against the market instead of just with it! And if that’s not good enough, he can now leverage his “thinking” by the power of three! All inside his IRA brokerage account!

Surly most investors reading my blog know that these new instruments are used primarily by professionals as short term trading vehicles, right? Guys like hedge fund managers, who are now propped up by our government, make a killing trading these things and you want to be just like ‘em, only better, right? You’re nimble, a trader’s trader.

Let’s take a look at a couple of new and popular ETFs, FAS which is 3X the financial sector:

Wow, that’s quite the track record. If you were excited about this 5 month old ETF and bet 5 months ago that financials would go up and held that investment then you would be down tremendously. And just look at the volume grow!

Boy, being 3X long the financials was a huge mistake! You must have meant to be in FAZ, the 3X INVERSE of the financial sector. Let’s see how you did using these new and wonderful ETFs being short the financials?

Shazaam! That is just ugly! What a great invention. I hope you can all stand back and look around at the financial industry and SEE what is going on TODAY. Did you see the mutual fund industry in a bubble at the time - honestly?

The current derivative backed ETFs are going to look silly a decade from now, just as mutual funds and Jim Cramer looks silly today. Again, what is the purpose, why are they allowed, and who profits? Is playing FAZ or FAS any different than going to the local casino? Is it more legitimate?

Here’s the next segment, talking about the Motley Fool – more historic perspective, enjoy…

"Betting on the Market" PBS Frontline (Part 3 - 10 minutes):

Great throwback review of the market... Nothing like going back in time to put the here and now into perspective.