Bubbles, Booms and Crashes part 6. Indicators

 Previously, I listed a few signs of booms such as reflexivity, money supply growth, psychological phenomena, and political factors without their more specific signs or indicators. It should be clarified how the indicators are reflected in national economies and in the prices of investment products. In numerical signals, the rate of change is important. In them, a longer-term decelerating pace of change anticipates a slowdown in bubbles, booms, which lead to crashes. There is no single sign or indicator that predicts the progression. The more characteristics you can find the better you know what you see.

Reflexivity has signs. One is to move further and further away from the average historical return. For example, stocks can be examined in comparison to the trend of ten-year average earnings per share, which has been around 17. The farther one moves from that figure, the more reflexivity is affected. As growth slows, reflexivity decreases. The interest rate of government bonds must be scrutinized because it makes more sense to pay higher prices for shares when it is low. The prices of houses or other share classes can be compared to the average trend growth for the reasons mentioned earlier.

The former is not the only sign. Declining interest rates and the fact that borrowing is based more on collateral values ​​than income are indicative of reflexivity. The first increases the chances of reflexivity and the higher leverage it requires. Higher prices combined with higher leverage increase the likelihood of reflexivity. The latter is an early signal that anticipates reflexivity. Lower collateral requirements and increases in collateral values ​​increase the probability of reflexivity and strengthen it.

In smaller countries, a significant rise in the amount of external money flows and the strengthening of the local currency signal reflexivity. So do loans to locals in foreign currencies. When foreign money notices the higher-than-normal returns offered by the local country, it rushes to the local market. Local incomes are rising and the currency is strengthening further, making the local market more attractive.

Reflexivity works in both directions. The previous phenomena also work in crashes, but they increase the decline in prices. They fall below average trends, increasing the decline, as interest rates rise, prices fall, and declining collateral levels increase borrowers’ willingness to increase collateral requirements. The transition from collateral requirements to income requirements will lower prices as revenue declines. The transfer of foreign currency away from local markets lowers prices, lowering the value of the currency, reducing the value of collateral previously issued, which also affects prices.

Several figures and indices can be examined to notice reflexivity. Changes in the supply of money tell something about it. Different countries have their own statistics. Not everyone is as reliable, but at least the US and eurozone money supplies can be tracked. There are also indices around the world to describe indebtedness opportunities such as the MBA Mortgage Index in the US, the address of the website can be found in the sources. The longer the maturity of the loans offered, the more certain the reflexivity will affect. Long 100-year mortgages or government bonds are a signal. The historically high volume of loans in the stock market compared to the indices indicates possible reflexivity.

Psychological factors are present in bubbles, booms and crashes. Let’s start with social proof and state that at its highest it applies to almost everyone. Everyone in their immediate circle is starting to have one or more people who are quickly enriched with popular investment products or have invested large sums in them, with at least a large amount of assets on paper. They are also eager to recommend their investments to others and say they are stupid if they don’t do the same. The more close colleagues or friends report on their successes and hundreds of percent returns in the short term, the closer the boom and the end of it is. The collapse has begun when the same people don’t say a word about investing or their losses. Social proof is mostly caused by amateur investors.

The progress of social proof can be monitored in Google Trends. There you can see how popular certain keywords have been at any given time. Peak moments don’t directly correlate with prices, but the highest search volumes are in the vicinity of both peaks and bottoms within a few months. The latter may be even better correlated.

Be fast! Buy before it becomes too expensive! The feeling of scarcity and hurry is one sign of a boom. Quick jumps in housing prices or multiple oversubscriptions of investment products indicate a shortage of supply or a sense of it. Low number of shares available in IPOs may be a conscious choice for listed companies. Two- or three-digit percentage increases in listed products on first trading days indicate scarcity. In the crash the supply of stocks is plentiful. This is reflected in the rapid decline. For example, a broad front before popular stocks lowers its prices in double digits on several days.

The majority of people follow a few authorities that seem credible. The latter may have been in other businesses before the bubble or boom. The general public gets promises from them where prices multiply fast. As the boom progresses, the promises increase. They sound nonsensical to those familiar with things. As the bubbles and booms progress, the warnings of the former follow, the anti-authorities of the booms, increase. At the same time, more people believe they are incomprehensible. In crashes, authorities and their promises are revealed to be either scams or their views wrong. During that time, the “Warren Buffets” will also start to get rich with their foreclosed assets. Their returns exceed averages by significant margins as the collapse progresses.

Excessive regard in one’s own abilities, possessions, and chances of success is reflected in excessive trust in both communities and individuals. The euphoria created by booms and bubbles increases confidence in significant and rapid economic growth. It can be seen e.g. as large-scale, absurd consumption patterns. Record prices are paid at auctions. You can see signs like the construction of the world’s tallest building or record-breaking massive construction projects that exceed their budgets. A sign of bust may be the interruptions in them.

It is particularly evident in individuals who, during the new economy, have earned significant returns, at least on paper, through either their investments or their business. They buy expensive cars and waste their money on status symbols. The phenomenon does not only affect individuals. One sign of the new economy is found in individuals who leave their jobs because they believe they can be investment professionals. They recommend the same to others. This “This time it is different” delusion is big.

The above factors reinforce the illusion of excess availability, but they are not all the causes for its existence. The media is a significant part of the strengthening. They give their followers what they want to hear during a boom. They want to hear that ”now is a good chance to get rich immediately,” etc. They dig up people who suddenly became rich and let them present their advice. It is common that the majority of journalists don’t understand enough to be able to question bad advice. They lift the wrong authorities on pedestals and write negative stories about how those who have invested for decades have lost their grip. They talk about how their investments don’t match short-term successes. The number of things moving from media placement is at its peak at the end of the boom or the start of the collapse. At the same time, their availability and popularity are at their highest.

There are many signs of political factors reinforcing bubbles and booms. One is tax cuts on certain investment products or real estate. Bubbles and booms may gain significant start-up momentum or accelerate as wealth is diverted to tax-advantageous destinations. Speeches by politicians and central bankers about the merits of a booming economy run rampant. Some of them may warn the public. Unfortunately, they do not lead to actions when they are important.

Promises to save investors are a sign of the moral hazard that has occurred in all booms. Promises ultimately lead to actions. Unfortunately, they are too late. The first capital injections for those who mismanaged their business are a sign of moral hazard and anticipate a boom in artificial respiration for too long. At the same time, the probability of a larger collapse increases.

The increase in the use of “alphabet soup” or other new investment products in language is a sign of a boom. Increasing supply to retail investors also speaks for itself. Their complexity can also tell about it. The more investment products you don’t understand, the more surely the bubble is growing. The deregulation is also a sign of a boom. Increasing them probably indicates the risks that have already materialized. Regulators are often late.

The interference of central bankers or politicians in market price formation are signs of bubbles, booms, and crashes. Purchases or price cuts by central bankers of investment products will increase bubbles and booms. Unexpected sales or price increases can signal or cause a risk of collapse. The boom can also be seen in the lack of supply regulated by politicians. For example, land use restrictions can tell about a real estate bubble. The rapid increase in supply indicates that the crash is approaching.

There are enough signals about the existence of bubbles, booms and crashes. Alone, they don’t tell much. Certain signals have been present in all the booms and collapses of recent decades: the shift from income-based to collateral-based lending, cheap money and the money supply it increases. Other signals are less relevant, but the more of them are found the more likely booms and collapses are present.

Crash signals are less important because they occur afterwards. They don’t help with timing of sales, but they tell about the likelihood of new investments making sense. The most important of these is the extensive and rapid price cuts of tens of percent. After that, you can start to invest carefully. In addition, “just crazy to invest now” and all the other post-panic messages on the psychological profile after the aforementioned collapses are signals of better investment moments.