“Booms and Busts Around the World Happen Whenever Central Banks Tighten or Loosen Monetary Policy.” John Mauldin

“The growth in the money supply doesn’t go to driving up prices for goods like toothpaste, haircuts, or cars. It goes to drive up prices of real estate, bonds, and stocks.” John Mauldin

“Please read Mr. Mauldin’s outstanding economic paper on “Bubbles” attached below or the key excerpts I have provided. I agree with every word of it. If you read it objectively, you reach three pretty simple conclusions: 1) Bubbles and busts have occurred regularly throughout history, in all types of assets around the world. 2) Excess liquidity flows from asset class to asset class. Bubbles and busts happen whenever central banks tighten or loosen monetary policy, and 3) Central bankers and investors never seem to learn from these bubbles and busts, and people, even sophisticated and experienced ones, get caught up in them. Human financial decisions when faced with uncertainty are naturally flawed. (In other words, these bubbles and busts will continue to occur; they are not preventable. Therefore, the majority opinion of The Financial Crisis Commission, ‘that the crisis was preventable’, is not correct. Also, human failings in dealing with financial uncertainty aren’t fraudulent or negligent acts, as some in government have claimed.)” Mike Perry, former Chairman and CEO, IndyMac Bank

Key Excerpts from November 2, 2013, investment letter “Bubbles, Bubbles Everywhere”, by John Mauldin, Mauldin Economics:

 “Easy Money Will Lead to Bubbles and How to Profit from Them”

“Central banks are trying to make stock prices and house prices go up, but much like the winners of the 2009 Darwin Awards, they will likely get more for their buck than they bargained for.”

“Central bankers hope they can find the right amount of dynamite to blow open the bank doors, but it is highly unlikely that they’ll be able to find just the right amount of money printing, interest rate manipulation, and currency debasement to not damage anything but the doors. We’ll see more booms and busts in all sorts of markets because of the Code Red policies of central banks, just as we have in the past. They don’t seem to learn the right lessons.”

“Targeting stock prices is par for the course in a Code Red world. Officially, the Fed receive its marching orders from Congress and has a dual mandate: stable prices and high employment. But in the past few years, by embarking on Code Red policies, Bernanke and his colleagues have unilaterally added a third mandate: higher stock prices.”

“Properly reflected on, this is staggering in its implication. A supposedly neutral central bank has decided that it can engineer a recovery by inflating asset prices. The objective is to created a ‘wealth effect’ that will make those who invest in stocks feel wealthier and then decide to spend money and invest in new projects.”

“Excess Liquidity Creating Bubbles”

“As we write Code Red, stock prices are roaring ahead. In fact, many asset classes are looking like bubbles from our cheap seats. (While we expect a correction at some point, when the Fed or the Bank of Japan creates money, it has to go somewhere.)”

“Veteran investors in high-yield bonds and bank debt see a bubble forming. Wilbur L. Ross Jr., chairman and CEO of WL Ross & Co. has pointed to a ‘ticking time bomb’ in the debt markets.”

“Government bonds are not even safe because if they revert to the average yield seen between 2000 and 2010, ten year treasuries would be down 23 percent. ‘If there is so much downside risk in normal treasuries,’ riskier high yield is even more mispriced,’ Mr. Ross said. ‘We may look back and say the real bubble is debt.’”

“Another bubble that is forming and will pop is agricultural land in many places in the United States….The bubble really started going once the Fed started its Code Red policies.”

“Why are there so many bubbles right now? One reason is that the economy is weak and inflation is low. The growth in the money supply doesn’t go to driving up prices for goods like toothpaste, haircuts, or cars. It goes to drive up prices of real estate, bonds, and stocks.”

“Excess liquidity is money created beyond what the real economy needs. In technical terms, Marshallian K is the difference between growth in the money supply and nominal GDP. The measure is the surplus of money that is not absorbed by the real economy. The term is names after the great English economist Alfred Marshall. When the money supply is growing faster than nominal GDP, then excess liquidity tend to flow to financial assets…That’s one reason why stocks go up so much when the economy is weak but the money supply is rising.”

“It is also why stock markets are so sensitive to any hint that the Fed might ease off on QE. Real players know how the game is played.”

“The rise in real estate, bonds, and stocks does not count toward any inflation measures. On the desk in his office at Princeton, Einstein once had the words, ‘not everything which can be measured counts, and not everything which counts can be measured’. Inflation happens to be one of the things that counts but can’t be measured (except in very narrow terms). Excess liquidity flows from asset class to asset class. As you can see from Figure 9.3, booms and busts around the world happen whenever central banks tighten or loosen monetary policy.”

“Humans Never Learn”

“Financial bubbles happen frequently. In the 1970s, gold went from $35 to $850 before crashing. In the 1980s, the Japanese Nikkei went from 8,000 to 40,000 before losing 80 percent of its value. In the 1990s, the Nasdaq experienced the dot-com bubble and stocks went from 440 to 5,000 before crashing spectacularly in 2000. The Nasdaq lost 80 percent of its value in less than two years. Many housing bubbles over the past decade in the United Kingdom, United States, Ireland, Spain, and Iceland saw house prices go up 200 and even 500 percent and then lose over half their value in real terms.”

“The U.S. market has had frequent crashes: 1929, 1962, 1987, 1998, 2000, and 2008. Every time, the bubble was driven by different sectors.”

“Economists and investors have spilled a lot of ink describing bubbles, yet central bankers and investors never seem to learn and people get caught up in them. Peter Bernstein in Against the Gods states that the evidence ‘reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.’”

“What is extraordinary is how much bubbles all look alike.”

“Bubbles happen again and again. The same basic ingredients are found every time: fueled initially by well-founded economic fundamentals, investors develop a self-fulfilling optimism by herding that leads to an unsustainable accelerating increase in prices. And each time people are surprised that a bubble has happened. As billionaire investor George Soros once said about financial cycles: ‘The only surprise is that we are always surprised.’”

“For example, the corporate bond market appears to be in another bubble. ‘We have a hyper-robust bond market right now,’ Dallas Fed President Richard Fisher, a former investment manager, said in an interview. These robust markets are part of the Fed’s policy intent, he said, but the credit market jump has put him on guard for a new destabilizing credit boom. ‘You don’t sit on a hot stove twice.’”

“Economists and investors though, repeatedly sit on hot stoves. Economic researchers have managed to create bubbles in laboratories. Economist Reshmaan N. Hussam and his colleagues not only managed to create bubbles once, they managed to bring the same subjects back in for the same experiment and still managed to reproduce bubbles. It didn’t matter if people were given fundamental information regarding what was available or not. It didn’t matter how financially sophisticated the participants were either: corporate managers, independent small business people, or professional stock traders. No one was immune from re-creating bubbles.”

“It seems that everyone is a born sucker…..Now it seems we chase asset prices. It is as if we are hard-wired to respond to movement in what market we are following. The conclusion from repeated experiments shows that it doesn’t matter if people live through one bubble or even two, they’ll likely fall for bubbles again. The smarter people learn from the bubbles. But they don’t learn to avoid them; they participate again and simply think they’re smart enough to know when to get out. This has been show many times in trading experiments conducted by Vernon Smith, a professor at George Mason University who shared in the 2002 Nobel Prize in Economics. As Smith said, ‘The subjects are very optimistic that they’ll be able to smell the turning point. They always report that they’re surprised by how quickly it turns and how hard it is to get out at anything like a favorable price.’”

“Anatomy of Bubbles and Crashes”

“There is no standard definition of a bubble, but all bubbles look alike because they all go through similar phases. The bible on bubbles is Manias, Panics, and Crashes, by Charles Kindleberger. In the book, Kindleberger outlined the five phases of a bubble. He borrowed heavily from the work of the great economist Hyman Minsky. If you look at Figures 9.7 and 9.8 (below), you can see the classic bubble pattern. (As an aside, all you need to know about the Nobel Prize in Economics is that Minsky, Kindleberger, and Schumpeter did not get one and that Paul Krugman did.)”

“Stage 1: Displacement, Stage 2: Boom, Stage 3: Euphoria, Stage 4: Crisis, and Stage 5: Revulsion.”

Please click here for an extracted copy of the investment letter Bubbles, Bubbles Everywhere, by Mauldin Economics

Posted on November 5, 2013, in Postings. Bookmark the permalink. Leave a comment.

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