Why Are Traders the Last To Know When a Bubble Is Bursting?

Former reason Editor in Chief Virginia Postrel has a fascinating column up at The Atlantic about how experimental economics helps to clarify why bubbles and crashes happen in the stock market. She concludes with two bits of sage advice as we look forward to a thousand years of bad returns:

For those of us who invest our money outside the lab, this research carries two implications.

First, beware of markets with too much cash chasing too few good deals. When the Federal Reserve cuts interest rates, it effectively frees up more cash to buy financial instruments. When lenders lower down-payment requirements, they do the same for the housing market. All that cash encourages investment mistakes.

Second, big changes can turn even experienced traders into ignorant novices. Those changes could be the rise of new industries like the dot-coms of the 1990s or new derivative securities created by slicing up and repackaging mortgages. I asked the Caltech economist Charles Plott, one of the pioneers of experimental economics, whether the recent financial crisis might have come from this kind of inexperience. "I think that's a good thesis," he said. With so many new instruments, "it could be that the inexperienced heads are not people but the organizations themselves. The organizations haven't learned how to deal with the risk or identify the risk or understand the risk."

More here.

Back in 2002, reason interviewed Vernon Smith, who won a Nobel Prize in economics for helping to create the field of experimental economics. Read all about it here.

Comments

[dbcooper]

I interviewed at a trading firm in London a few years ago. They were an exceptionally dim group of people with big egos and little education. They told me I couldn't do math. I pointed out my qualifications, sighed, and left. I am glad I stayed in a technical field.

[David E. Gallaher]

"it could be that the inexperienced heads are not people but the organizations themselves."

If we were all peaceful anarchists we wouldn't need to be worrying about getting organizations up to speed.

[Warren]

"I think that's a good thesis," he said. With so many new instruments, "it could be that the inexperienced heads are not people but the organizations themselves. The organizations haven't learned how to deal with the risk or identify the risk or understand the risk."

An organization is a body of people, usually notably unorganized.

[David E. Gallaher]

Warren,
Organizations arise spontaneously. The trouble with most of them is that they were formed and then tweaked by individuals compulsive about forming them.

[P Brooks]

People become complacent; they think tomorrow will be like yesterday. They want to believe Alan Greenspan knows what he's doing. They assume there is an infinite supply of "next greater fools".

They believe the nice, well-dressed lady when she says, "This property will NEVER be worth less than it is right now."

[Mo]

A big problem is that bubbles tend to kill contrarians along the way. Try going short on tech stocks in 1999 or short home builders/real estate in 2005 or even oil at $100 in January. The margin calls will bankrupt most people or companies. Markets rely on shorts to provide information, but if all the shorts keep getting wiped out, that info gets lost until the peak. That's the real danger of bubbles.

[T]

The margin calls will bankrupt most people or companies. Markets rely on shorts to provide information, but if all the shorts keep getting wiped out, that info gets lost until the peak.

The market can stay irrational longer than you can stay solvent is what I was always told.

[domoarrigato]

One time I showed the head of my trading desk a 20 year chart of interest rates to make a point. His response: Shit that will get you fired doesn't even show up on that chart.

[R C Dean]

The market can stay irrational longer than you can stay solvent

That's why I won't go short even in markets that are obviously and grotesquely overvalued. Other people have more crazy than I have cash

[Mo]

The market can stay irrational longer than you can stay solvent is what I was always told.

That's the succinct way of putting it.

One time I showed the head of my trading desk a 20 year chart of interest rates to make a point. His response: Shit that will get you fired doesn't even show up on that chart.

It depends. If you're wrong with the crowd, you keep your job. If you're wrong by yourself, you get fired. There's safety in the herd.

That's why I won't go short even in markets that are obviously and grotesquely overvalued. Other people have more crazy than I have cash

When oil was at $130, I planned on investing in an Short ETN to prevent myself from getting margin called broke (figuring I can eat paper losses). The night before I did it, my friend told me a story of his coworker that had his Short ETN fold up because the prospectus noted that at oil at $125, the margin calls would be enough that the ETN would have to fold. The guy bought at Oil = $100 and had to suck up all the losses just as oil was about to peak. This story made me cut my investment (and profit) in half.

[Fluffy]

The market can stay irrational longer than you can stay solvent is what I was always told.

Well, let's consider the non-irrational members of the market for a moment.

Say you realized that a real estate bubble was in place, and that it was being fed by Federal Reserve policy and fiscal policy.

What's the rational response to that realization?

You still can't fight the bubble, because the Fed can feed the bubble for as long as it wants.

The real estate bubble popped both due to its own life cycle, but also because the Federal Reserve finally started raising rates. That means that in order to rationally respond to the bubble, you had to properly guess when the Fed would choose to exercise its arbitrary power to raise rates.

We can't expect "rationality" from the market when a key data point is the will of the Fed board of governors. You can get close to rationality, if you do a good job of engaging in "Fed Watch phrenology" and tea-leaf reading, but you can't ultimately know or model it.

[domoarrigato]

It depends. If you're wrong with the crowd, you keep your job. If you're wrong by yourself, you get fired. There's safety in the herd.

More than anything in the actual article - that comment is EXACTLY why traders are always the last to know.

[Mo]

The real estate bubble popped both due to its own life cycle, but also because the Federal Reserve finally started raising rates. That means that in order to rationally respond to the bubble, you had to properly guess when the Fed would choose to exercise its arbitrary power to raise rates.

You're so wrong, it's not even funny. The Fed started raising rates from June 2004 to July 2006. Rates were flat until October 2007. The pop started in January 2007. Housing prices continued to rise DESPITE rising interest rates in 2004-2006.

More than anything in the actual article - that comment is EXACTLY why traders are always the last to know.

They're not the last to know, they're just the last to react. It's easier to hold off when you're trading other people's money. Though with the new clawback features firms are implementing on bonuses, it'll be interesting to see how traders respond.

[fresno dan]

With all the new fangled financing (AKA lying) its hard to draw a straight line between interest rates and the bubble going up, and than goinng down. And It's not like it was completely irrational...for a while. And thats a big problem. These things take years...did it start in '97...2003...2004? Humans don't really have the patients to wait 2 or 3 or 4 years. Plus you have to listen to people tell you how wrong you were...for years. And they sure hate you when you say "I told you so."

[Warren]

So OK. I'm a rational investor and I'm watching my government destroy the economy. I'm thinking that the US government will default on it's debt within the next few years and the dollar will not be worth the paper it's printed on.

I've got just about all of my nest egg in IRAs and a 401k.

So what's a rational investor to do?

[R C Dean]

I've got just about all of my nest egg in IRAs and a 401k.

So what's a rational investor to do?

I really, really hope you have a self-directed investment option for your 401k.

If you really believe that the dollar is about to collapse and the US government will default on its debt, buy gold. If you can self-direct the investments in your retirement accounts, then you have a plethora of gold bug vehicles to buy into.

[Lefiti]

Like the weather, economics is complicated, but unlike the weather, economics must never be intereferred with. Government intervention in the economy is like birth control--it is against God's will.

Let us pray.

Hail Market,
Full of grace,
Prosperity is with thee.
Blessed art thou among systems,
and blessed is the fruit
of thy womb, Capital.
Holy Market,
Mother of Goods,
pray for us consumers now,
and at the hour of our bankruptcy.
Amen.

[Mo]

Warren,
While the advice RC gave you is indeed the correct advice if you believe that the US government is going to default on its debt, you should keep in mind that gold is trading at 30 year highs.

IOW, it is like a peak oil believer buying oil at $130 in the summer.

[robc]

That's why I won't go short even in markets that are obviously and grotesquely overvalued. Other people have more crazy than I have cash

That is why I didnt short SCOX. I would have got in about 16-18 and it ran up to 24. At what point would I have wimped out? I dont know, but there has to be a limit and I was worried for a while that it wasnt going to crash and burn like it did.

[robc]

It depends. If you're wrong with the crowd, you keep your job. If you're wrong by yourself, you get fired. There's safety in the herd.

This also applies to football coaches (and other sports, but especially football). Only, they get fired anyway - but, not being wrong by yourself keeps you in the old boy network for the next job.

[R C Dean]

you should keep in mind that gold is trading at 30 year highs

Which is why I won't buy gold. I just cannot bring myself to believe that a commodity at a 30 year high has much appreciation left before a massive correction. If the gold market wasn't even more riddled with irrationality than nearly any other, I would be sorely tempted to short it, but see my remarks above about the relative supply of my cash v. other people's crazy.

[Fluffy]

You're so wrong, it's not even funny. The Fed started raising rates from June 2004 to July 2006. Rates were flat until October 2007. The pop started in January 2007. Housing prices continued to rise DESPITE rising interest rates in 2004-2006.

Several points:

1. If the Fed had overshot on their easing, the first several rate increases would not be sufficient to pop the bubble, as they would only bring monetary policy back from an easing bias to a neutral bias.

2. http://www.bloomberg.com/apps/cbuilder?ticker1=MTGEFNCL%3AIND If you look at the 5 year chart for mortgage rates, fixed mortgage rates lagged the Fed's rate increases, as they often do. Mortgage rates peaked in July of 2006, then declined substantially again, and then repeaked midway through 2007. That double top works lines up pretty well with a bubble pop date of January 2007.

3. Not that I agree with that date as the pop date or anything anyway. New Century's death was the first major public event of the bubble "burst", and although that took place in the first quarter of 2007 their earnings had started to sour and their stock started to drop in the second half of 2006 - pretty much right on schedule as the effects of the first of the two rate peaks hit.

4. Monetary policy was only half the problem. I think an extremely stimulative fiscal policy had a great effect as well. The ongoing [and rising] Bush deficits "doubled up" on the Fed's mistake when monetary policy was too loose, and masked the immediate effects when policy was too tight.

[Brandybuck]

you should keep in mind that gold is trading at 30 year highs.

It's not at a 30 year high, it's not even at a one year high. Gold prices are very volatile right now. But don't take my word on the prices, see for yourself: http://www.usagold.com/gold-price.html Of course, those charts might just be part of the conspiracy...

[Mo]

RC,
Totally agree. That's why I didn't disagree with your analysis, but wanted to warn Warren of the theoretical world of hurt he's getting in on if he goes long on gold. You're right about gold investors as well, they're the Truthers of financial markets.

Fluffy,
Way to change the explanation after the first one was disproven. And mortgage rates peaked when the Fed Funds rate peaked, in July of 2006. Though you should note, housing prices declined as mortgage rates declined over the next 10 months.

If you're going to use an arbitrary event as the canary in the coal mine, Ameriquest shutting down retail in May 2006 is a good one to pick. I like using Jan 2007 because it's the first year the Case-Schiller has a YoY decline. Though August 2006 is alright too because is a MoM decline.

[Mo]

Brandybuck,

They're not at the high, but they're in the neighborhood. The recent high is the 30 year high. When something is trading 60% the above the previous 25 years' high* and only 10% below the high from 9 months ago, I feel pretty comfortable saying it's trading at its highs. I would feel the same way if I said the same about $130 oil 6 months ago (after the peak).

* Ie. the high from 1982-2007

[domoarrigato]

You're right about gold investors as well, they're the Truthers of financial markets.

Don't tell John C. Randolph that, he'll be mighty pissed...

[TB]

If you're worried about downside risk, why not just buy out-of-the-money options instead of short selling?

[domoarrigato]

TB, vol is wicked expensive in gold, especially downside vol. people I talk to in the industry say mines been using their gold off take as collateral for borrowing for the last year. Sure enough, the best cure for high gold prices is high gold prices - and the amount of production that has been made economic by $1000 gold is huge - and a lot of these guys are capitalised now, and have their hedges set. Prepare for a gold glut.

[Brandybuck]

The recent high is the 30 year high.

Do you remember that previous high thirty years ago? Do you remember the big collapse soon afterwards? Not the collapse of the economy all the goldbugs were predicting, but the collapse of the gold price. Thirty years later and it's FINALLY back where it was.

Collectible gold coins are still a good bet, but bullion is too volatile right now. It simply does not have the magical powers that the krank goldbugs attribute to it.

[Head]

If I was a maniacal goldbug austrian with shotguns, handloading equiptment, 1 years worth of dried beans, and a bomb shelter, I'd be pretty pissed off at the treatment I'm getting here at a supposedly libertarian magazine.

Really. Fucking. Pissed.

If that's what I was...