David Cay Johnston: You Can Only Push People So Far
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HYMAN MINSKY’S SEVEN BUBBLE STAGES
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 [written in 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!
Weekly initial jobless claims are still over 400,000 but they came down very substantially in the May 14 week to 409,000, for a 29,000 fall following the prior week's 40,000 decline (prior week revised 4,000 higher to 438,000). Stock futures are rising in reaction to this report.
Auto and weather effects were no more than isolated in the week's data which sees the four-week average only very slightly higher at 439,000. A decline in next week's data would push the four-week average down for the first time since early April.
Other readings show an 81,000 decline in continuing claims in data for the May 7 week to 3.711 million. The unemployment rate for insured workers is unchanged at 3.0 percent.
Falling interest rates gave a big 13.2 percent boost to MBA's refinance index which has now risen 33 percent over the last five weeks, a span that has seen 30-year mortgage rates drop more than 50 basis points. The average 30-year rate fell seven basis points in the May 13 week to 4.60 percent for the lowest level in six months. But low rates are not boosting buyers, not at least in the latest week as the purchase index fell 3.2 percent to upend four weeks of gains.
Housing activity is continuing to confound and is refusing to establish any kind of uptrend. Housing starts in April fell back 10.6 percent, following a revised rebound of 12.9 percent in March. The April annualized pace of 0.523 million units posted below the median market forecast for 0.570 million units and is down 23.9 percent on a year-ago basis. The drop in April was led by a 24.1 percent fall in the volatile multifamily starts component, following a 30.8 percent jump in March. The single-family component dipped 5.1 percent after rebounding 7.0 percent in March.
The good news within the report was an upward revision to starts in March which were revised up to 0.585 million from the original estimate of 0.549 million.
By region, the drop in starts in was led by a monthly 23.0 percent plunge in the South with the Northeast declining 4.8 percent. However, gains were seen in the Midwest and West, up 15.7 percent and 3.7 percent, respectively.
Housing permits have been volatile in recent months but trending flat. Housing permits declined 4.0 percent in April, following a 7.5 percent surge the month before. Overall permits came in at an annualized rate of 0.551 million units and are down 12.8 percent on a year-ago basis.
The bottom line is that housing is flat and at anemic levels. Likely, we need to look to other sectors in the economy to keep the recovery moving forward. Recovery in housing appears to be some time off but that is not a surprise to many.
Industrial production surprised on the downside for April with weakness led by a drop in auto assemblies. Overall industrial production in April was unchanged, following a revised 0.7 percent gain the prior month (originally up 0.8 percent). Analysts had called for a 0.4 percent advance for the latest month. Notably, manufacturing posted a 0.4 percent decline in April, following a 0.6 percent gain in March. Auto assemblies likely were weighed down by supply disruptions for parts from Japan. Excluding motor vehicles, manufacturing rose 0.2 percent after a 0.4 percent advance in March. Moving to other sectors, utilities increased 1.7 percent after gaining 0.7 percent in March. Mining rose 0.8 percent after a 1.4 percent jump the month before.
Within manufacturing, durable goods dropped 1.0 percent in April. The output of motor vehicles and parts fell 8.9 percent after increasing 3.6 percent in March. Nondurables edged up 0.1 percent in April after advancing 0.5 percent in March.
Overall capacity utilization in April slipped to 76.9 percent from 77.0 percent the prior month. The April rate fell short of analysts' estimate for 77.6 percent.
Today's report is disappointing at the headline level and for total manufacturing. But the auto industry is relatively healthy based on demand and recovery should be expected soon for assemblies. Non-auto manufacturing is mixed but still net positive.
The first indication on this month's activity in the manufacturing sector points to a slowing in an otherwise still solid rate of growth. The Empire State index fell nearly 10 points to 11.88, a level that's well over zero to indicate month-to-month growth but below April's 21.70 level to indicate a slowing rate of growth.
The news is definitely not that bad with new orders and shipments still strong, though again showing slower rates of growth than April. Unfilled orders show an increasing rate of growth with inventories posting a sizable build. Job indications are special positives with the number of employees on the rise and the workweek on the rise. Price readings are a concern with inputs rising sharply to their highest level since 2008 and output prices, that is prices that customers pay, at a high and slightly accelerating level.
A plus in the report is data on the six-month outlook where optimism across nearly all readings is on the rise. This report is mixed but does point to healthy growth. The Philadelphia Fed will post its report on the manufacturing sector on Thursday.
Net foreign purchases of long-term U.S. securities slowed slightly in March to a moderate $24.0 billion from $27.2 billion in February (revised from $26.9 billion). Foreign purchases totaled $54.7 billion in March offset but by $30.7 billion in purchases of foreign securities by U.S. residents.
Holding back March's inflow were purchases by official accounts which slowed. In a positive, private investors showed strong demand for U.S. securities especially equities. Private demand for Treasuries, corporate bonds and government agencies all show month-to-month gains. Total inflow, which includes short-term securities, rose nearly $10 billion in the month to $116.0 billion.
A negative in the report is Treasury disinvestment by China where holdings slipped more than $9 billion to $1.15 trillion. This dip is limited but does extend a long trend of monthly decline. Holdings by Japan, which is the second largest foreign holder of Treasuries, rose nearly $18 billion to $907.9 billion. This reading will be interesting to watch to see if Treasury selling picks up as Japan rebuilds.