This week I watched the stock market take a 2.5% downward dive that would have made the Flying Wallendas fling their arms skyward and arch their backs with a gymnast’s pride. The simple ‘ups’ and ‘downs’ of markets are comfortable with a few points’ move on a daily basis – positive reports on the economy foster the natural rise of the markets, but it is the fear events which cause stabbing doubt in the minds of investors: fear diminishes oxygen; you sell or hyperventilate; prices drop; then prices drop more to where the falling price action becomes its own fear event and the Wallendas, Ventilators, and the Lemmings all fly off the cliff to the waters below … poof!
I could have said biff! bang! splat! or kapow! but those are really batman and robin terms, and those guys are so '60s' -- what would have been MOST appropriate would have been for me to say pop! because that’s what bubbles do and that’s what we’re floating inside right now. What happened this week was not yet a fullblown pop! but rather a correction.
In the late 1980s, a transformation began in the world economy whereby companies started selling debt obligations (bonds) to finance expansion, friendly takeovers and ‘leveraged’ buy-outs which were not always so friendly. It gave the company working capital to grow, which would in turn entice people to invest money into their stock which would surely rise in value. Michael Milken made millions as a bond trader selling ‘junk’ bonds from high-risk companies at high interest rates. The key word of this paragraph is ‘debt’. When you buy a bond, you don’t buy a product; you buy indebtedness from the issuer; it is a promise to pay with interest.
Take one speck of sand and toss it onto a beach and you’ll get the scale of one dollar in the world’s debt pool. It seems limitless but it’s finite and though it seems to naturally wash in and out with the tides it is still fundamentally a distortion of reality - most of the debt in the world way over-extends the currency said to back it up. It takes a minor quake -- small fear events to slap your cheeks like a 3-Stooges skit, or a 2.5% drop -- to see clearly that there’s more investment income promised than which can ever be returned. When a distortion like this is made evident, people start pulling their money until the scenario accelerates and the bubble pops.
People buy, people sell. Let’s say we put 100 people in a big room. 50 people have 5 pieces of gold each that they want to sell and the other 50 people are in the market to buy gold with the cash they brought in. Each cash-person has a good idea what their top price is to pay as a buyer, and each gold person knows what their bottom line is to sell their precious metal. Nobody’s in a hurry to buy -or- sell, everyone just wants a good deal. Ok, some vendor comes into the room with a salami sandwich and tells the buyers that someone lastnight robbed Fort Knox of all their gold. Holy Crap, no more gold … EVER! Buy, buy, buy !!
The buyers change their price guidelines and start buying in a mania – whatever the price, this may be the last chance to ever buy gold. Of course, one seller overhears the salami sandwich guy talking, and understanding human nature, becomes one of the first sellers to demand higher prices. Many of the sellers decide to wait, they don’t sell until the buyers have bid the prices up to an astronomical level and they make a killing. Some buyers desperately want more gold and they know that all that gold is still in the room and offer higher and higher prices, becoming very loose with their cash. Some order more salami sandwiches.
As a group, buyers start running out of money, sellers start running out of gold … but the mania continues … the sellers stay on the carousel, buying their gold back, thinking they can turn it around at a profit as the prices continue to skyrocket. Things are are moving so quickly, buyers and sellers flip sides frequently ... and then the salami guy comes back in and says oops, the robbery was a hoax and Fort Knox has decided to SELL all its gold at half price, and by the way, here are your sandwiches.
Holy Crap, the price of gold in the room plummets as the latest rumor spreads and sellers unload their gold for whatever cash they can get, knowing dang well that everyone else is doing the same and will accept lower and lower prices just to make a sale. They don’t care, they just want some cash, they want out cuz when they leave, they gotta pay the sandwich guy. The one poor seller gazing out the window at the pigeons on the ledge never heard the salami guy or the sales ruckus. When the trading din suddenly halts, he walks out of the room hungry, with the same measly five pieces of gold in his pocket worth less than a pigeon -or- a sandwich (or even a pigeon sandwich).
The bidding that took place in the room was part of a mania. Bubbles are the end results of manias, or distortions; irrational reactions to news that compels selling or buying at prices way outside the normal curve or company valuation, with expectations of an endpoint in profit-land. In the Netherlands from 1634 to 1637 an investment mania happened when a certain slow-growing hybrid tulip bulb with lovely mosaic stripes became so popular that people would pay in tracts of land to own just one bulb. On February 3rd, 1637, bidding ratcheted up to one more notch in the bulb markets and then suddenly people simply stopped buying. Nobody could sell because nobody was buying, sellers began lowering their prices hoping to unload their bulbs but the prices quickly crashed and the market bottomed-out. The bubble popped and countless people lost their life savings in an over-valued speculative venture. Those that got out the day before when the bulb markets opened for that week became filthy rich.
When the stock market crashed in 2008, it was the default of Lehman Brothers (another big debt-seller using mortgages as collateral) and the mind-boggling prospect of unravelling their gordian-knot of debt that acted as the pin that popped the real estate bubble. Two weeks after they declared bankruptcy, a rolling ‘Wave’ started spinning through the ballpark grandstands, with the markets falling 400-500 points a day, ultimately dropping 14% and compelling people to pull out their life savings and stuff it back under their mattresses.
The Bubble had been inflating for years with gusto and hope of profits, and was coming from the lightspeed expansion of investment paper tied to residential mortgages. What am I talking about here?! Owning a home with a porch swing and picket fence was the American dream and real estate prices were rising steeper than the first turn at Talladega. Imagine all those loan officers fanning mortgages on the racetrack sidelines with the drivers hanging out the windows grabbing them one-by-one at the Start-Finish line at 216mph and you get a pretty good picture of the velocity of debt-related documents making their way to the investment underwriters.
This was the Real Estate Boom -- loan sales couldn’t keep up with demand and the normal safe-practices cycle of credit-rating reviews and income documentations were replaced by sales-incentives and robo-signers -- distortions of reality -- mortgages churned faster and faster into sellable debt packages; securitizations called Mortgage-Backed Securities (MBS). Just like bonds, these MBSs produced a monthly income through interest paid on mortgage loans. Investors could sink their money into an MBS and hope for a handsome income from their investment. To make it worse, these MBS’s themselves were tied even more insidiously into overlayed securitizations that created over-leveraged debt obligations that were so incomprehensible at the time of the Lehman’s request for bankruptcy, that the lawmakers in Washington simply washed their hands of it and let Lehman’s rubberband ball unwind on its own.
Discussion gets complex after this but what we’re looking at is financial pornography – that being, derivatives. Derivatives are the pole-dancers of the investment community. They’re hot and supple and for a couple of bucks they’ll do a lap dance on your life savings. The problem is that in the previous paragraph I used the word ‘hope’. You hope for reliable monthly payments. To create the velocity of mortgage sales (and justify hiring all those danged robo-signers) you gotta settle for lower quality borrowers: that’s right, sock-it-to-me SUBPRIME, baby. Just like Milken in the 80’s, less attractive credit ratings meant higher interest rates (yeah, baby!), and a higher monthly income to the investor.
Whoopeee! uh …. pop?!
Don’t get me wrong, discretely letting off a little gas at a party is ok, but a 2.5% drop is letting it rip. Nonetheless, a drop like this is still not a bubble popping; it’s a release of pressure. The stock market has been building steam ever since the Federal Reserve began the TARP program to prop up insolvent US banks. Um, because they bought too much junk from Lehman? But now that we’re nearing the end (June 30th) of their dollar print-o-mania (called QE2) we’re noticing improvements in the economy aren’t we?
Anybody bought a steak recently?
9.1% unemployment, a housing doubledip, oil at $100/barrel, gross purchasing for manufacturing is down. No, we’re not improving. Mark Vitner, Senior Economist at Wells Fargo indicated on NPR June 3rd that if the Unemployment Forecast was unfavorable [it was], we can expect another year of No Growth [uh-oh]. The latest drop in the market is a precise indication that things have not improved. The market is in a distortion where the stock prices of far too many companies do not accurately represent their underlying valuations. Like I said, when investors wake up to these distortions they pull their money very quickly and stuff it in a safe place.
Tulips photo courtesy Tamera J Edwards(FB)
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