Friday, October 10, 2008

Sorting Through the Bubbles and the Crashes

Now that we have seen a full bore, global panic and crash, it might be worth sorting out how many bubbles there have been, and which of the three patterns identified by Minsky and Kindleberger (and first formally modeled by me, dating back to 1991) each has followed.

So, the first and most fundamental has been the housing bubble. This seems to have followed the pattern of gradually up and then gradually down, with no crash. The peak was end of 2005, and if one believes the various Shiller indexes, it still has a good 10-40% to go or so. Of course real estate bubbles rarely crash, unless they are for vacant land as in Florida in the 1920s, as people will generally not dump their own homes in a panic.

The next was the derivatives bubble. Whereas the housing bubble fairly clearly started around 2000 or 2001 after the tech stock crash, the beginning of the derivatives bubble is shrouded in mist, still much about it is not well known. However, it looks to have followed the peak followed by a period of financial distress and then a crash pattern, the most common pattern for major bubbles. The peak would appear to have been August, 2007, and the crash was the outright financial market panic on Sept. 17, 2008, after Lehman Brothers was allowed to fail and AIG nearly went under, with Treasury yields dropping to 0.06% at one point. This crash ended with the announcement of the bailout of AIG and that there would be a broader bailout, although clearly the credit and derivative markets have not really recovered from that crash.

Then there was the oil bubble, which looks more like the theoretically preferred one that goes up, peaks, and then pretty much crashes, which happened in July, although it has continued to sink since, and very rapidly in recent days.

Finally there is the behavior of the stock markets. While there was a bubble in US stocks in the 1990s, the more recent behavior has not been particularly bubbly. The sharp crash of the last few days has been a negative bubble, an epiphenomenon emanating from the crashes of the derivatives and credit markets, collateral damage, although quite serious, and threatening to take down the real economy as well (bankruptcy for General Motors anybody?).


Michael Ejercito said...

General Motors is going bankrupt because they are not making products enough people are willing to pay for. said...


I cannot disagree, although having nationalized health insurance a long time ago would have helped them out a lot.

Regarding GM there are plenty of ironies. Back in the 1950s there was a Sec. of Defense under Eisenhower, Wilson, who intoned that "what is good for GM is good for the country." Hmmm. Too bad they did not get on the bandwagon for more energy efficient cars and so on earlier.

A deeper irony is that in the work of Alfred Chandler, and later of Oliver Williamson, on the history of the corporate form, GM stands out as the original "M-form" multi-divisional corporation, an idea partly drawn from the DuPonts, who sort of did it in their company, and owned a lot of GM stock in the 1920s when this happened, and Alfred Sloan, for whom MIT's School of Management is named. The M-form cobbled together "U-form" companies like railroads into larger entities that were supposed to be better managed, and by 1940 or so, if not earlier, certainly by 1945, Gm had surpassed Ford to be the biggest automobile company.

But then we may be seeing the ultimate follow-through of Alfred Marshall, whose U-shaped long run average cost curve was really about the life cycle of a firm, and Marshall even identified the problem of getting too big "managerial diseconomies of scale." GM a long time ago became so big and so bureaucratic that it became incapable of doing anything very innovative or even very intelligent. It is indeed a dinosaur. So, its downfall will be downfall of the first multi-divisional firm, swollen to extinction by its own earlier success and size.

Shag from Brookline said...

Remember when IBM was in trouble and creative destructionism looked like it might do it in? IBM turned thing around. What did IBM do that was right that GM (or even GE!) might do to survive?

The Animal said...

"Negative Bubble"? Stocks are just getting back down to their historical valuation levels. They could overshoot it in the coming days though. said...


I think that GM needs a loosening of the credit markets and getting a better mix of cars.

the animal,

Oh, what is the historical valuation level? Based on P/E ratios?

I would say that there was a reason for the historical P/E ratios to be too low, the fall of socialism globally. Part of the P/E ratio was a risk of nationalization of assets somewhere around the world. That crashed to a very low level after 1991, although it has crept back up somewhat more recently. That allowed for a non-trivial increase in the "fundamental P/E ratio."

As for now, let me be clear. We had a bubble in the stock market in the 1990s. I do not think we have had a bubble there since, although arguably stock prices were mildly overvalued. What has happened is a crash of the fundamental, due to the crashes in the housing and deriviatives markets and the freezing up of the credit markets. Although there is a lot of irrational panic and revulsion going on, there is also clearly a reasonable expectation that profits and dividends are about to fall and fall a lot. So, earnings are about to fall. That says that prices should fall just to maintain a constant P/E ratio.

GM is a perfect example. Its stock price is low because its profits are falling, and expectations are that they will fall even more in the near future. The collapse of its price is not the fall of a price that had become inflated due to wild speculation in GM stock. Has there been wild, or even mild, speculation in GM stock? I do not think so.

Michael Ejercito said...

Although there is a lot of irrational panic and revulsion going on, there is also clearly a reasonable expectation that profits and dividends are about to fall and fall a lot. So, earnings are about to fall. That says that prices should fall just to maintain a constant P/E ratio.
So what reasonable expectiation is there that profits at ExxonMobil and Altria Group would fall a lot? said...

Who is Altria?
ExxonMobil's profits tend to be strongly, if imperfectly, correlated to the price of oil. It is plunging now, so their profits should fall also.

Michael Ejercito said...

Altria produces food, beer, and cigarettes under brand names. said...

They might hang in there better than some others.

Anonymous said...

Who is Altria?

Altria is basically what used to be Philip Morris. they needed a new gen name to hide from their seedy public reputation :)