About Booms, Bubbles and Busts

Noah Smith has an interesting piece on bubbles and busts:

For the past half-century, the academic macro story has gone something like this: There is a general trend of rising growth and prosperity in the U.S. economy, caused by steady improvements in technology. But this steady course is disturbed by unpredictable events — “shocks” — that temporarily slow growth or speed it up. The shocks might last for a while, but a positive shock today doesn’t mean a negative shock tomorrow. Recessions and booms are like rainy days and sunny days — when you look back on them, it looks like they alternate, but really they’re just random.  

Yes, the economy is cyclical and the duration of the cycles might vary every time. The more relevant questions to ask are do all booms result into bubbles, do all bubbles result into busts, do all busts lay the foundations for new booms, and most importantly how could one benefit from this seemingly perpetual cycle?

Here’s what I wrote about bubbles and busts on this blog a couple years ago:

There are a thousand definitions for a bubble. Some say it is a huge trend you have not participated in. Others stick to a more conventional description – unsustainable valuation.

One of the purposes of free markets is to correct excesses. If you believe that something is a bubble, devise a plan to profit from it. Don’t just stay on the sidelines. There are several ways to participate:

1) You could become part of the momentum and help early short sellers to part with their money. George Soros loves bubbles: “When I see a bubble, I buy that bubble, because that’s how I make money”.

2) If momentum is not your forte, then short it and see where it gets you. Just because something seems overly expensive, it does not mean that it won’t become more expensive. Hundreds of money managers thought that the housing market in the U.S. was in a bubble in 2004. They ended up being right, but between 2004 and 2006, many homebuilders stocks quadrupled in value. You cannot afford to lose 300% of your clients money. Most will take it back, when you down 30%, so even if you end up being right, you might not even be able to benefit from it. Timing is of crucial importance when you bet against a bubble, because “the market could remain irrational longer than you could remain solvent” – as Keynes pointed out. You could wait for a technical breakdown and short the crap out of the bubble – some say that catching trend reversal are the most favorable risk/reward trades/investments. Keep in mind that the higher the potential reward for each unit of risk you take, the lower the probability that it will actually work. This is how financial markets work. If you could make 10 times your money in a deal, the odds are high that this deal might end up wiping our your entire investment.

3) Wait for the bubble to busts and then pick up the pieces at extremely low prices and sell them during the next bubble. Here’s the thing. You need leverage to create bubble. Financial leverage. Leverage is the main reason why when a bubble bursts, the market over-shoots to the downside and send asset prices to extremely low and some would call them “favorable” prices. Without a big bubble, you cannot have a big bust. And without a big bust, you cannot pick up assets at extremely attractive valuations. So stop complaining. As Peter Lynch likes to say: “ I don’t know what exactly causes big market corrections, but I know that the track record of most successful long-term investors would be impossible without them ”. To benefit from a bust, you need to have an ample supply of cash, because credit markets are often “closed” when prices are at their lowest and perception of risk is elevated. People think in terms of capital preservation, not in terms of making more money.

Most people take the passive approach of side-lined viewers. Everyone has an opinion, but very few have an idea how to turn that opinion into an actionable plan. It is the trading and investing ideas that matter.

If you believe that something is a bubble, you could actually profit from it. Usually, people who point fingers and call something a bubble, do it for one main reason – to declare to the world that they will never put their money there and other people should do the same, because “it will end badly”.  And you know what? Maybe it will. The financial history is full of booms and busts and actually both precipitate each other. Learn to live with it. Bubbles are not going anywhere. Neither are busts. But you could make a big difference in your life if you learn how to participate in them.

The end of one boom is usually the beginning of another. Capital just rotates. As we wrote in The Next Apple:

Every crisis brings an opportunity. Every bust in one area of financial markets puts the foundations for a boom in another area. Money never sleeps. It constantly goes somewhere – sometimes, because of rational reasons, but other times, because of sheer speculation. Nevertheless, as long as humans are involved in financial markets, there will be booms and busts, crises and recoveries.

America went into recession in the early 2000s, and Americans went to school to gain another diploma. As a result, education stocks rallied to the sky. Between 2000 and 2004, shares of Apollo Education went from $ 10 to $ 100.

Terrorists hit the Twin Towers in 2001, and America went to war. As a result, defense stocks appreciated substantially. Between 2002 and 2005, shares of Kevlar  makers Ceradyne went up 1800%.

The bust in tech stocks in the early 2000s alienated regular Americans from stocks, and they decided to put their money into houses. Homebuilders’ stocks went up five times and more in a fairly short period of time, before they went bust. Between 2001 and 2005, shares of Beazer Homes went from $ 40 to $ 370, Toll Brothers went from $ 7 to $ 50, Ryland Group went from $ 7 to $ 80, etc.

The Fed’s aggressive monetary easing coupled with emerging markets’ hunger for basic materials caused a massive spike in demand and inflation. As a result, commodities went through the roof. While market averages deteriorated in the first half of 2008, many basic material stocks quadrupled. Yes, in the second half of 2008, they gave up most of their profits and then some more, but they created incredible opportunities for people who were simply following price trends and had an exit strategy. Between 2007 and mid-2008, shares of potash maker Mosaic went from $ 15 to $ 150.

The financial crisis of 2008 – 2009 brought all stocks down on their knees. Many small caps were priced for bankruptcy. Most of them survived and went up more than 1000% in the ensuing four to five years. Mattress maker Select Comfort was trading near 25 cents per share in early 2009. In early 2015, it is trading near $35.

Big corrections create the opportunity for big recoveries. The European sovereign bond crisis of 2011 and the overall slow employment recovery in the United States encouraged the Federal Reserve to launch a series of unprecedented monetary policy injections with the code name “Quantitative Easing.” Waves of capital flooded public and private markets and caused material appreciation in most financial assets.


Howard Marks’ latest memo on risk has sparked interesting conversations on the web. Mr. Marks points out that volatility is very incomplete definition of investment risk:

Risk is something people worry about and therefore demand compensation. What people fear most is the possibility of a permanent loss.

Permanent loss could occur for two reasons:

a) an otherwise temporary blip is locked in when an investor sells during a downswing – whether because of a loss of conviction; requirements steaming from his time frame; financial exigency; emotional pressures or

b) the investment itself is unable to recover for fundamental reasons

We can ride out volatility, but we never get the chance to undo a permanent loss

Howard Marks looks at risk from the position of a long-term investor, not from a trader’s perspective.

A trader is not worried about taking a permanent loss. Permanent loss on some of his trades is part of his process. Sometimes being wrong is not a choice. Staying wrong always is.

A temporary dip could last quite some time and turn into a much bigger dip. A 10% loss takes an 11.11% gain to recover from. A 80% loss takes a 400% gain to recover from. There is an opportunity cost behind every decision you make. A losing asset could manage to fully recover to your initial purchase point, but what is to say that you could not have sold at a small loss and used to proceeds to buy another asset that ends up actually making you money. As a trader, you don’t have to make money in the first one or two stocks or assets you buy. The market is an opportunity machine. It provides a good number of opportunities every single week.

Is uncertainty risk? No, uncertainty is always here. You don’t need to know that something will happen with 100% certainty, in order to take advantage of it. Circumstances will never be ideal, but if you follow a process with an edge you will end up with more than you have began with.

Risk is what’s left after you think about and prepare about anything that could go wrong. If you are prepared for it, is it really a risk or a mere part of the process of trading? Forget about measuring the probability of each scenario that could unfold. If you have an action plan for every possible scenario, then those scenarios are not risk events, but just possibilities. Therefore a good definition of risk is a black swan.

According to Nicholas Taleb, black swans are “large-scale, unpredictable and irregular events of massive consequence”. This definition is a little too grandiose. Black swans could be very subjective. If you don’t know what you are doing or if you are not prepared for a possible event, it could be a black swan for you. It is not a black swan for someone, who is prepared for it. Thanksgiving is a black swan event for the turkey, not for the butcher.

You might know about certain risks, but if you are unprepared for them, they remain risks for you. Sometimes, the cost of insuring against every possible risk is too high and you deliberately decide to take your chances.

Basically, the most practical definition of risk is something you are not prepared for.