The best explanation on when this current bubble will burst...
It may be foolish to say everything follows some deterministic equilibrium like "markets only go up," but you must have a hypothesis about when & what is going to change that brings the market down...
I have been writing a number of emails about how markets have become more bubbly, fragile, narrative-drive, and the second-order nature of market exuberance. How much danger are we in? When will the bubble burst, if it ever does at all?
Today I want to share with you the most lucid explanation of “irrational exuberance” and “bubbles bursting” that I’ve come across in a very long time. It is from Part 2 of my interview with Rob Johnson, President of the Institute for New Economic Thinking (INET), which was just released this past Thursday. You may read a brief summary about it here.
I consider the following back-and-forth to be an absolute highlight of our interview. Rob’s logic may be easier to follow in listening than reading, so I put down the timestamps. Either way, these are some very brilliant words that I highly recommend you to read:
Tiger: [00:56:42] I want to hear your thoughts on all the recent trends in finance that we're seeing: not just the GameStop saga, not just the rise of Bitcoin, not just that the stock market has become more detached from fundamentals, but most important the fact that we seem to be in another era of irrational exuberance – a huge boom that a lot of people say there is no way we don't crash eventually because this boom is simply supported by Federal Reserve policies, liquidity, easy money, cheap capital, low interest rate. None of this seems sustainable.
But on the other hand, it also seems that the expert class won’t be able to get us out of this horrible situation anytime soon, so this has to be the new normal that will continue for a long time, and one would be foolish to think that this booming markets will crash because stocks only go up in today’s macro environment. Which side do you think is more plausible?
Rob: [00:57:43] I would encourage people to look at George Soros’s book The Alchemy of Finance. There's no sense in which you can say everything follows some kind of deterministic equilibrium, but you have to have a hypothesis about what's going to change that brings the market down and its timing.
I had a lot of friends who were short sellers when I worked in the hedge fund business – like Jim Chanos, who's quite famous and involved in the unmasking Enron's fraudulent positions through some of their special purpose vehicles. People like Jim and others in that realm used to say to me: It's really dangerous to short a technological innovation that has no earnings because there's no way you can disprove that hypothesis as long as people have that subjective psychological conviction that the price isn't going to come down.
You take something like the steel industry, then you say we can look at 100 years of data on the steel industry and the P/E (price/earnings) ratio goes from 5 to 23, and if it's at 28 now, you think the pendulum's rocked way over to one side and it'll probably mean revert, so being at 28 is a dangerous position to be in. [You can’t really do this for the booming technology sector, so it’s much harder to predict a tech bubble bursting.]
I don't see interest rates coming back up until the real economy comes back up. And the real economy will either come back up through fiscal spending on real projects like energy transformation, or through a rise in wages – especially a rise in wages in the lower 2/3 of society where the propensity to consume out of every dollar earned is much higher. So therefore, potentially a redistribution of wealth and income to a more level place would create a more resilient and stronger aggregate demand, which would allow interest rates to go back up.
Then you might say interest sensitive sectors (like tech/growth stocks) are going to get hurt, other sectors (like cyclicals/value stocks) are going to do well, and the Fed will follow that because there won't be an inflation danger until that aggregate demand strength is there. So we might continue to wallow in this low interest rate environment for a very long time.
But to go back to the Soros question: what's the catalyst for busting what people are calling a bubble? If you say to me they're going to stay with accommodative monetary finance for the next decade, then you're not going to want to get off the train, especially when bond yields are like 1.5 percent.
So I don't know. I your question is a good one. I'm not in the cockpit. You’d do much better getting my former colleague Stanley Druckenmiller to be on your podcast and explore these issues.
That notion that Soros has is: We don't know the future, and you got to tell me what you know that the rest of the world doesn't, and when they're going to find out so that it will catalyze a change in their perceptions and eventually send the market down.
I don't have that hypothesis. I'm not studying it closely enough to to give you, but that's the process I would have followed had I still been in the business.
Tiger: [01:02:14] It's very hard to do hypothesis testing, especially when the underlying distribution is shifting, and when you do not know what the actual underlying probability distribution is. I suppose this is the “radical uncertainty.”
Rob: [01:02:29] You can be right about the outcome, but you can be wrong. John Maynard Keynes said “the market can stay long longer than you can stay solvent.”
Tiger: [01:02:45] Yes – that is why short sellers get burned all the time, because they may be right eventually, but they couldn't stay solvent (like some of these hedge funds shorting GameStop may eventually be right, but they cannot make their margin calls til that day).
You must have a hypothesis to predict the downfall
What Rob was trying to say is: Don’t just shout that the market will crash, please actually point to me what would make that happen and when! Don’t just tell me how I’m wrong or why things seem irrational, but actually tell me how things are supposed to be, why, and what would make the status quo change!
I have previously written about George Soros and his reflexivity theory. The phenomenon of reflexivity gives rise to boom/bust cycles, in which markets and human perceptions reinforce themselves. We believe the prices will be higher, so we push the prices higher, which validates our previous judgment that prices will go higher, and so on.
But that’s not the only central point of reflexivity. What I see to be the more important takeaway to understand is the idea of inflection point, at which the prevailing bias gets proven wrong:
Eventually, a turning point was reached. In the conglomerate boom it came when Sol Steinberg was unsuccessful in taking over Chemical Bank. In the technology boom the critical event was the auctioning of 3G licenses in Europe. Telecom companies were obliged to make inflated bids in order to justify their inflated stock prices (Soros, The Alchemy of Finance, p.30).
Sure, markets fall when “the bubble bursts,” but the bubble gets burst not by the worsening of fundamentals per se but by an inflection point event – it could be some random Black Swan event (like this ship getting stuck in the Suez Canal), or a Fed policy announcement that reverses market expectations and trigger market freefall. Either seems highly likely to me; I’m just not good enough to develop that hypothesis in a more holistic way. (If I could, I would start a hedge fund today…).
But regardless, without a sound hypothesis it is meaningless to just say “oh I think we’re in a bubble and things might come down soon” – that’s basically saying nothing.
And by the way, some more on the Suez Canal situation:
The saga of irrational exuberance is to be continued with more examples & charts coming soon…
Disclaimer: Needless to say, my emails are just casual commentaries. I try my best to write them thoughtfully and with care to provide some alternative perspectives on various issues, but please do not treat them in any way as financial advice for your own investment.
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