Recognizing Asset Bubbles – preferably before they burst – from Economic Behavioural Changes They Breed.
Asset bubbles are formed by the rapid rise in asset prices, far outrunning the asset’s fundamentals. Sudden wealth gained through such rapid rise in asset prices initiates marked changes in the economic behaviour of its acquirer: those who were active participants and beneficiaries of the rapid price rise. Worryingly, some of these changes are not for the good. As all asset bubbles will eventually implode, when they do so, these newly acquired economic behaviours significantly exacerbate the ensuring distress or panic.
However, for an astute investor, such behaviours inform him that matters are in excess, and the time for the music to stop is not too far (the music stops when the asset prices whose rapid rise has increased household wealth stop rising). He could turn risk-averse and adjust his portfolio for hard times, raise cash to capitalise on opportunities that might emerge later, or take other precautionary measures. These differences in economic behaviour are so subtle that only a person who is a keen observer of world affairs and society can correctly decipher them.
Increased, excessive consumption spending is the most conspicuous among such economic behavioural changes. Initially, the market participant’s spending rate was determined by his income – salary, wage, interest, or dividend. As his wealth increases, he feels more prosperous and starts being generous with his spending. However, he won’t utilise much of the increased wealth towards spending. Since it is rising rapidly, he let it ride. Meanwhile, all his spending comes from his hard income – salary, and wages.
A negative aftereffect of this changed spending behaviour is that – his savings rate (how much he saves out of his income) declines. In certain situations, particularly those characterised by heightened euphoria and widespread speculation, his spending is so lavish that it often exceeds his income. He finances those excess spending with borrowings made possible by the abundant money available during asset bubble periods. Nevertheless, he remains cool about them, because he expects that his wealth, which is rising fast, can easily pay for his borrowings.
This trend of rapid price rise, easy wealth, and changed spending behaviour can go on… until the music stops. The music must stop because it is unsustainable. But when, how, or what will stop it is hard to know. No one can foresee it. However, what is most troubling about the rapid rise in asset prices and its promise of fast and easy wealth is that they are (irresistibly) seductive. Despite being concerned about the elevated price level, many find it difficult to stand on the sidelines and watch, while others get rich. Sooner or later, more people get in: let us dance too so long as the music goes on.
But only when the music stops, which it eventually does, do people realise the excesses to which they have succumbed. The music stops when the rise in asset prices slows down… then stops rising… soon starts declining… and finally starts falling precipitously. Now the asset bubble has imploded. The investor sees his paper wealth declining. However, due to the inelastic nature of consumption spending, he cannot rationalise his spending, that is, reduce his spending as his (paper) wealth declines. So more borrowing follows. The most vulnerable are those who had quit their job and left the labour force during the easy times. They quit because their investment income has overtaken their salaries or wages… and continues to rise fast.
When the music stops, the economic behavioural changes precipitated by the wealth increase strongly influence the severity of the outcome. The final straw is broken when the expectation that his rising wealth will pay for his borrowing and spending crumbles. It is then that the chaos begins. It would be instructive for an equity investor to be aware of these economic behavioural changes, principally spending habits, to safeguard his portfolio against the chaos. But being personal, people’s spending habits are inconspicuous to us. So, how do we get a sense of it?
Manias and asset bubbles happen when hysteria breaks individual boundaries and attains a massive scale. In other words, when irrational actions happen collectively. Here, the irrational actions we are talking about are asset purchases for easy wealth and expanded consumption spending. As the actions were collective, they surely will have visual manifestations in society. Anyone attentive enough can identify the differences in economic behaviour in a society that is fuelled by rapid asset price rise – hopefully before the bubble bursts.
People flounder wealth on larger houses, second homes, vacation homes, cars, lavish weddings, and expensive vacations. Getting children married off is important. However, it is concerning when many people flounder wealth on such events. People squander money through excessive indulgence in pleasure such as exotic international vacations, frequent eating out in expensive restaurants, and excessive purchase of clothes, shoes, accessories – everything more than necessary. Whether floundering or squandering wealth, the underlying theme behind them is gaining public attention by showing off their wealth.
The changed economic behaviour caused by the rapid rise in asset prices… particularly spending behaviour… is not a prerogative of the individual. Businesses too are infected by the euphoria. During economic euphoria, businesspeople are so optimistic about their demand forecast that they expand investment spending to capitalise on the opportunities. The availability of cheap money that usually accompanies economic euphoria makes those investments easy.
When stock prices are elevated, a firm’s cost of capital remains low (stock prices and cost of capital are inversely related). During asset bubbles, those inverse relations are at their extreme such that it is too irresistible to let go of the opportunity to raise capital so cheaply. Under such conditions, unnecessary or more than warranted investment occurs – that is, more than accorded by the demand forecast made in normal times.
Only when the asset bubble pops and the hold of mass hysteria wanes from the psyche of business owners, do they realise the mistake they have over-invested. But it is a costly mistake. The new capacity brought about by the additional aggressive investment made during exciting times remains mostly underutilised. Additionally, the increased cost brought on by these investments such as depreciation, maintenance and labour costs, and fixed costs act as a drag on the firm’s bottom line. Revenue doesn’t expand much, but costs rise disproportionately. There is a steep decline in profitability and stock prices decline, consequently.
However, an interesting thing is that the over-investment bug that infected firms’ thinking during economic euphoria and asset bubbles was widespread. Not just one or two firms, but almost everyone in the industry or sector or, in the extreme, all in the economy, had succumbed to the lure of cheap money and had over-invested. However, the severity of the glut in capacity is realised only when the bubble pops. A few firms fail to keep up with their costs and go bankrupt. Correcting the excesses will take a long time as the mismatch between demand and supply is severely high.
Asset bubbles are formed when the initial optimism surrounding an idea or innovation that promised significant productivity gains and profit opportunities escalates into euphoria and speculation – a financial mania. During its final stages, investors are attracted to an asset by its rapid price rise, with no consideration given to its fundamentals or whether the earnings expectation behind the rapid price rise is realistic. Moreover, investors use leverage to maximise their profit during these exciting times. The trouble begins when the price rally halts.
Usually, it is an event that brings an end to the rally. The event disturbs investors and punctures their elevated confidence. They are forced to question the exaggerated expectations incorporated into stock prices. Prices stop rising. Investors’ expectations that they could meet their borrowing obligations and spending habits from the increasing asset prices now start crumbling.
When asset prices were rising rapidly, lenders were generous with their lending practices. Their generosity was guided by the confidence brought about by the rapid rise in asset prices. Since prices have stopped rising, lenders turn risk averse by raising their lending standards which slows credit flow into the market and the economy. It is only by selling assets that leveraged investors could now cover their borrowing obligations and spending habits as new borrowings have become hard to come by. Consequently, asset prices that have stopped rising start to decline due to the distressed sale of assets by investors to meet their borrowing obligations.
Initially, when asset prices were rising rapidly, investors rushed into the asset – stocks or real estate – under the false belief that prices would keep rising. But now under the changed conditions, those belief’s hold on investors’ psyche has started loosening. Even investors without precarious spending habits and borrowing obligations consider selling assets because the hope of huge wealth gain through rapid asset price rise has been shattered. As prices are declining with no end in sight, now the top priority is avoiding wealth destruction.
Progressively, the impact of these developments slowly starts reflecting in the economy. Consumption spending slows down, which is the first reflection of market troubles in the economy. Soon, businesses feel the slowdown. Their earlier forecast of demand seems unrealistic now. They feel overstaffed largely because of the hiring done during the exciting times. Now the topmost thought is to keep their businesses afloat which might require letting go of workers, which causes unemployment to rise. They cancel their earlier planned investment spending which exacerbates the slowdown.
Meanwhile, asset prices keep declining. Prices might now have fallen to levels warranted by fundamentals, but that couldn’t prevent further price declines. It is distress and panic the decisive drivers of price changes. The liabilities brought on by spending habits, borrowing obligations, and loss of wealth – these are the major factors playing with investor sentiments now.
When we say asset bubbles or asset prices, the asset is mostly either stock or real estate. We saw earlier how massive movement either upside or downside in their prices have repercussions on jobs and the broader economy. During euphoria, borrowings were used to purchase both assets and contributed significantly towards their rapid price rise. During panic too, borrowings play a significant role in exacerbating the price decline as investors are forced to liquidate their positions to meet borrowing obligations.
However, one difference between stocks and real estate is the duration of the borrowings. For stocks, the borrowings are ultra short-term margin money with maturity ranging from one day to a maximum of one week. Therefore, when distress or panic occurs, investors don’t have much sway to wait for conditions to normalise. In contrast, in real estate, the borrowings are often of long maturity (five years or more). Therefore, when there is distress, investors have the leverage to wait out the storm.
Another thing is that these two assets are strongly correlated. A boom in stock prices makes many rich. They buy bigger houses, second houses, holiday homes, vacation homes, etc. This ignites a boom in real estate. Likewise, people who have made money in real estate buy stocks igniting a boom in the stock market. The share of real estate, construction, and infrastructure companies in total stock market capitalisation is significant. These stocks decline when there is any distress in the real estate market. This negatively impacts the overall market sentiment, triggering a decline in other stocks and the general market.
Banks feel distressed and might incur capital losses due to real estate delinquencies. Consequently, they may tighten credit standards, choking other sectors of liquidity and igniting distress in those sectors. Those sectors suffer and the stock prices of companies in those sectors decline. In the stock market, when prices decline, some investors may go underwater – their assets aren’t enough to cover their borrowings. Brokers or lenders call in their loans. However, some investors fail to meet their borrowing obligations, which escalates the troubles.
In extreme situations, a few major financial institutions might fail causing distress in the financial system, which runs on trust. When trust declines, many lenders become reluctant to roll over their borrowings. This worsens the situation, and now, not just financial institutions, but a few non-financial institutions might fail too.
A distress may or may not aggravate into a panic. Likewise, a panic may or may not intensify into a crisis. It all depends on how much froth has built up into the system. Certain economic behaviours are symptoms of forth in the financial system. Increased consumption spending, widespread speculation, financing asset purchases and spending with borrowings, floundering and squandering of wealth are a few notable ones. A few bubbles in the froth may swell into larger ones whose implosion could severely impact stock prices. Investors who can identify them through the economic behavioural changes they breed and position their portfolio accordingly are the sharp-witted ones.
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