How do bubbles happen? (A mechanical demonstration)

A lot of skeptics over the existence of bubbles like to believe that just because a market is clearing at a given price that it means that price is an appropriate valuation for that asset. They said this about stocks and they said this about housing. After all, if the price got out of line with what it should be, more supplies would come on line and knock the price down.

Well, there's an issue with that. At the end of the day, demand and supply for assets is driven by what the buyers and sellers believe they can get for those assets. That expectation should be reasonably informed by the rational expectation of future earnings (with stocks it is profits and with real estate it is an equivalent level of rent), but as we know it often isn't. When the expectation about future prices becomes detached from rational expectations of underlying fundamentals, the demand and supply curves take on a life of their own.

Click on chart for bigger image

Like all microeconomics exercises, this is crude, but it gets the point out. Demand curves are denoted with "D" and supply curves with "S". The red lines show the market at the starting point. Then, for some reason that could well originally be related to real fundamentals, demand shifts out to D-2. This creates the expectation among holders of the asset that future prices will be higher than current prices and so the prices at which each holder of the asset is willing to part with it increase, shifting the curve in and prices rise further. Skipping ahead a few phases, demand for the asset again shifts out as buyers are trying to race in as their expectations of future prices get wildly out of hand and supply again shifts in as the owners of the asset have their expectations raised as well. 

The problem is that all the while the fundamentals of the pricing of that asset have not changed to support these expectations. At some point, this is realized and both demand and supply shift back to their original locations, causing a fairly huge drop in price.

Now, the exercise above also happens on the downside as well. It happened in March of 2009 in a big way. That was a huge "negative bubble" where expectations about the future prices of assets were irrationally pessimistic. This was partially informed by really bad information about likely future earnings just as the housing bubble was partially informed by, well, lies that the typical return on a house price was between mid-single digits and double digit percentages and that prices could never ever fall. This was so pervasive that it made its way into mathematical models for the pricing of mortgage backed assets.

The point of all of this is that bubbles will always take place in the context of what looks like a properly functioning market. Let's take housing for a moment. A great deal of research suggests that the only factor that really matters for determining the direction and magnitude of change in house prices is the inventory to sales ratio. Housing bulls in mid-2005 said that we couldn't possibly be in a bubble because the inventory to sales ratio was so low (sometimes less than 4 months supply). However, thinking about this in terms of the exercise above, the reason the supply was so low was because the market was withholding supply that would have otherwise been on the market because sellers were holding out for higher prices because their expectations had become similarly warped. The bubble deniers essentially thought that a bubble would only exist if prices were advancing 20%+ in the context of an inventory to sales ratio of 8 or more. Once homeowners and developers began to develop more rational expectations about what they could reasonably expect for their future prices, supplies picked up while demand dropped due to buyers' expectations coming down.

This is all useful to think about when we look at China's housing market and also gold.