Dear Thoughtful Investor,
Are we in a bubble? That’s the question everyone wants to know. After the bursting of a tech bubble (2001) and a real estate bubble (2008) the term “bubble” entered the american lexicon. The collective conscience remembers how a bubble *feels*, that is: a sustained increase in prices of an asset year over year. Some argue that “this time is different”; meaning we’re so smart now that either fundamentals do not matter or fundamentals support a very high price. The last five years we have seen asset prices increase year-over-year in two categories: equities and real estate. People have an impending sense that this feels like the last two bubbles and are asking, “Are we in another bubble?”
This will be our introduction to bubbles. We will spend much more time on this in future letters. For now, here is the lifecycle of a bubble in eight chapters:
1) Money - as capital available for investment (vs. consumption) is looking to buy financial assets that generate a return
2) Money flows into an asset expected to produce a return. Demand and then prices increase on speculation instead of value. Speculation being the hope that someone else will come an buy it for a higher price later without any improvement made to the asset.
3) Prices increase further because of increased debt available to purchasers. New borrowed capital floods a market because returns are so good one can borrower money to buy the asset, sell it for more, and keep the difference (isn’t leverage wonderful?).
4) The debt is short-term and needs to be either refinanced or paid back from sale of the asset.
5) An outside force (usually a bank or central bank supplying the inexpensive debt capital) stops or reduces its lending for purchase or refinancing of the asset.
6) The portion of the demand supported by cheap debt disappears. The supply of sellers stays the same. Prices begin to come down to find a new equilibrium.
7) As prices come down, it triggers the debt-to-equity ratios on the existing assets financed by debt. Lenders demand immediate repayment which forces borrowers to put the asset up for sale thus further increasing the supply-side of the market causing prices to drop further.
8) People cry and wonder why they didn’t see this coming. Politicians point their finger at someone (bankers? CEOs?) and advocate for more regulation. Savvy investors that were sitting on a lot of money buy up lots of assets at low prices. Fortunes are made and lost.
So to our question, “Are we in a bubble?” When focusing just on residential real estate, the answer is a *qualified* NO. By qualified I mean that the little trillion dollar microcosm of the economy that is the residential real estate market is not technically in a bubble, it’s driven by a shortage of supply, but the entire world of residential real estate is priced and predicated on a financial system that is itself extremely unstable - we are essentially in a ‘money bubble’.
Going back a millennium or two in financial history there are many examples of localized money bubbles the end in currency devaluations and complete losses of wealth for anyone holding their purchasing power in that currency. What is unprecedented today is the world-wide currency collusion. People often debate about whether “this time is different”; if we view economics through a financial lens we can unequivocally say that No, this time is not different. However what is different this time is that central banks are coordinating their actions in expanding the money bubble extremely carefully. Historically when one bank/central bank printed a lot of IOU money (a la Federal Reserve Notes) investors could refuse to take those IOU dollars and move their purchasing power to a different currency causing the crash (in the form of hyperinflation) of the currency that had over-printed. What is the solution if you are a central banker? Get rid of all the hiding places - if all currencies are inflating at similar rates then there is no where for purchasing power / wealth to go to find a safe-haven.
Think of someone blowing up a balloon. As long as the balloon fills evenly the rubber stays thick enough to keep the balloon intact as it gets very large, but if there is a thin spot in the rubber and as it fills up that thin spot protrudes out like a tumor on the surface of the balloon that will be a weak spot that causes the entire balloon to pop. Similarly, if all central banks collude and coordinate efforts they can get the balloon (the fiat money bubble) much larger before it pops, if one currency over-prints it will create a weak spot that threatens the whole unstable system. We are not in a real estate bubble or an equities bubble, we are in a global currency bubble. Head for the hills! Although there may actually be a few places to protect and preserve our purchasing power.
to be continued…
A Thoughtful Investor