Did the Recent Silver Bubble Conform to Our Understanding of Bubbles?

Yes. Yes it did.

Let's think back to this old post of the evolution of a bubble.

As always, click on the image for a larger picture. Essentially, silver conformed to the basic tenant of a bubble that, because of rapidly rising expectations of future prices, suppliers of silver became unwilling to release supply on their old supply schedule. For instance, if I held 100 ounces of silver while it was trading at $15 an ounce, I may have been willing to put twenty of those ounces on the market once the price reached $20 in a more regular time. However, when I see prices go hyperbolic, I reassess the situation and hold on with a "wait and see" approach. My supply schedule shifts in. We saw this in the early stages of the silver rally where suppliers and buyers seemed to be having their expectations change more or less in tandem. What was the tell tale sign of this? Volume did not accelerate all that drastically until the last few weeks. Now, this can be the signs of something other than a bubble and I will discuss that in a minute.

Now, it's normal for volume to spike on one-off events like a big earnings report. For volume to increase massively, independently of major events in the context of a large rise is actually not normal. Case in point, Apple (AAPL):

Most of Apple's rally since early 2009 has happened in the context of remarkably stable volume. There hasn't been a huge surge in the number of shares traded during most of the advance. Clearly, this would provide evidence that the suppliers of Apple shares (i.e. current owners) have shifted in their supply schedules as prices have advanced. However, one key trait about Apple's advance is that it typically stalls until rejuvenated by a good earnings report. In other words, the advance is sustained by commensurate news regarding the fundamental improvements in the company's future earnings potential. To underline this point, Apple only trades at about 12x next year's earnings. If anything, one could argue that investors are discounting the possibility that the current trend in earnings might not be sustained.

To return to silver for a moment, there was no particular rationale for sustaining its rate of increase aside from the fact that it was increasing awfully quickly so one would want to buy in. Clearly, an increasing number of investors didn't buy into this idea and liquidated their positions right into the most hyperbolic portion of the increase. Volume surged in the last couple weeks of the rally, far eclipsing the daily average volume of the past several months. What was astonishing, and this is what tipped me off, was that there were enough speculative buyers to sustain the rally in the face of substantial liquidation. Clearly, speculators had become unhinged. The options markets reflected this at the end the last week of April where long-dated put options for SLV in the low 40s were trading at substantial premiums while long-dated call options above $50 were not. In other words, the options traders expected things to get ugly for silver by the end of the year. I decided, based on the frenzy, that silver was going to burst extremely quickly and decided to trade the June $42 puts. I have now liquidated two out of the three positions at large gains.

Now, let's try to piece this all together into a comprehensive picture of a bubble. You may remember from an earlier post back nearly a year ago that I laid out three criteria for spotting a bubble:

1. Is the asset or asset class in question fundamentally more attractive than other alternatives?
2. Is there either little information available or is the information corrupted in some way?
3. Are market actors incorporating available information or are they doing so in a rational way?

Silver began rallying for a real fundamental reason which is that the dollar is nearly constantly depreciating and high rates of money supply growth imply a central bank willing to devalue the currency for some time. This is usually a conventional reason to trade in precious metals as a hedge against inflation. However, the increase in silver far exceeded this fundamental reason as one will note that the dollar declined maybe around 10% depending on the measure you use in the time silver increased more than 150%. Still, there was a reason why the asset class of precious metals, broadly speaking, and silver in particular would be attractive.

On the second point, people have no idea how precious metals should be valued and economists have rarely ever been able to construct a reasonable model for how precious metals can be priced. Their industrial uses are never enough to justify their prices and their sentimental or emotional values to people are impossible to value. Further, there are a lot of people who corrupt what information is available with articles like "Silver going to $200 an ounce?"

On the third point, the answer was clearly no. The increase in volume wasn't based on any event, but on a short term frenzy where people were beating each other over the head with higher and higher bids to get into a crowded market. 

Take this into account with the fact that, like in all bubbles, silver followed the tradition of the trashiest asset in an asset class performing the best. Precious metals are generally in a bubble and silver is the trashiest among them and it performed the best. In fact, platinum performed the worst.

The silver bubble conformed to every basic tenant of what we understand about bubbles and the fact that several people, myself included, were able to call it should not be surprising. By the way, applying th criteria laid out here and in prior posts, you can clearly define Apple as not being in a bubble and the same applies to the overall market advance over the past two years. A large advance (50%+) does not necessarily indicate a bubble, but it does warrant examining the conditions surrounding it. 

Silver Blowing Away Gold (Again)

With geopolitical instability continuing to be a pressing issue, it is no surprise that the previous metals are performing well once again. As was the case a few months ago, silver continues to trounce gold.

About 90% of the time, in speculative markets you will find that the "lesser" product outperforms. 

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. 

Hong Kong Property Prices

We have previously discussed the property price bubble in mainland China as well as a similar bubble in Australia. Hong Kong, too, not surprisingly has been a center of quite a lot of speculative activity. There's a good post here about it: http://www.favstocks.com/hong-kong-bubble-hong-kong-residential-property-prices-july-2010/2024975/

I read a Bloomberg article today discussing whether or not it will be as bad as 1997. I really rather doubt that because while prices are approaching similar levels, incomes have grown notably in Hong Kong since then. However, there is little doubt that even with that income growth prices have still outstripped people's ability to afford them. This is all despite admirable attempts by the government to stop the bubble from building. 

On a related topic, the mainland Chinese government is rumored to be introducing a property tax in the fall. http://www.bloomberg.com/news/2010-09-21/china-may-unveil-property-tax-in-october-to-reign-home-prices-report-says.html A property tax similar to that in the U.S. does serve as a buffering mechanism to restrain house price bubbles for two reasons. One is that it adds a significant annual carrying cost so that you are dissuaded from sitting on property waiting for the right price. The other is that it cuts down on your expected rate of return and the tax is immediately capitalized into the house price. 

I will point out that states with high property taxes generally were spared from the housing bubble in this country, at least the most direct effects of it anyway. California and its peculiar property tax system actually encourage bubbles because house values are capped for property tax purposes at artificially low rates until they are sold. Depending on the rates China introduces, this will have a major effect on the housing market in China. Those sitting on investment properties that presently have no tenants will find the costs too great and be forced to sell while prices generally will take a hit. I think this is an interesting experiment on China's part to try to rein in a bubble before it reaches unmanageable proportions. However, it may be too late.

Another Take on the "Bond Bubble"

Here's a somewhat more well supported take on the bond market from Angry Bear than what you'll see most places. His model suggests that bonds are properly valued at the moment and were actually somewhat cheap not that long ago. I haven't looked much into his model yet to see if there's something I disagree with in there, but given levels of GDP growth and inflation, it could well be that present bond prices aren't that overvalued.

I don't happen to buy into the thesis that bonds are a bubble in the same way that stocks were in 1999 or housing was in 2006. I think they are only modestly overvalued on an absolute basis, but they are very unattractive to stocks at the present time. Let me put it bluntly. Do you think that the total return of bonds, which will be the present yields at best considering prices are likely to drop as interest rates rise, will exceed that of stocks over the next five or ten years? Even after adjusting for the relevant risk premiums, stocks are quite a bit more attractive than bonds at the moment.

More Talk of a Bond Bubble...

We discussed the issue of what a bubble in US Treasuries would mean a while ago here on Finance Monitor, but it seems that this is becoming a more popular subject. Take this MSNBC story for instance. Many of the same arguments that we have made here appear in the article which, among others, include the argument that dividend yields on high quality, consistent earning stocks are currently higher than treasury rates even before the possibility of capital appreciation.

For our earlier discussion on the matter, look here. Since the writing of that piece, yields have fallen nearly another 70 basis points.

One point I would like to make here is that bubbles in credit markets are more difficult to assess than they are in equity markets and real estate markets. Generally, I would say that if there is very robust issuance with not the slightest pressure on interest rates, that might be a sign that investors are too complacent with credit conditions. As of right now, I think bonds may be due for a serious correction, though it is uncertain how severely overvalued bonds are. So far it hasn't happened yet, despite my (and several others') repeated concerns.

Keep your eyes peeled on this one.

How Big is the Chinese Property Bubble? Pretty Big

I stumbled across a bunch of charts the other day and this one in particular caught my eye: http://www.businessinsider.com/chinese-land-prices-2010-7#likewise-price-increases-are-killing-income-increases-14 (Credit goes to Jing Wu, Joseph Gyouko and Yongheng Deng at NBER)

What I have said for some time is that despite migration patterns providing a substantial level of support to real estate in China, there is a fundamental problem where price gains have far outstripped income increases. This is also the reason I don't buy the idea that all of these houses are being bought strictly with cash, or at least cash that isn't at some point supported by debt. It just isn't possible.

Just to give you some idea of what a price to income ratio of over 20.0x in Shenzhen means, here in the U.S. California had a price to income ratio of right about 10.0x before prices started plummeting to about half of their all time high. Other markets still had decent sized corrections with price to income ratios of only 4-5x. Generally, much north of 4x is considered to be on the edge of pushing it nationally here while some markets can sustain, over time, more like 5-6x. I've seen some countries that can apparently sustain near 7x, but even for those countries that seems to be the point at which prices stagnate and wait for incomes to catch up.

Returning to China, it is true that there is regional variation, but that has been true in every real estate bubble in history. Here LA, New York, Miami, Las Vegas, Phoenix, Milwaukee, Cleveland, and Detroit all had very different dynamics. In the U.K., London, Liverpool, Manchester, Brighton, and Newcastle had varying degrees of excess. The same applied in Spain in the 2000s and Japan in the 1980s. It's a very non-compelling argument to say the least. What's more is that price to income levels mask another trait of real estate excess which is that those on the bottom end of the income spectrum often get caught up in the frenzy and buy much more house than they can afford in otherwise not particularly overpriced markets such as Atlanta.

It is unclear how much further this has to go, but perhaps Alex can expand with some first hand details on what he saw there.

On Spotting Bubbles: Part 1 of Many

One of the most fascinating phenomena in financial markets is the "bubble". Defining a bubble is somewhat of a tricky art form. I think most people would agree with this quote by Justice Potter Stewart on the issue of obscenity: "I know it when I see it". We all think we know a bubble when we see it, but do we really? I have found myself looking for definitive methods for spotting bubbles before they are clearly out of control and I wanted to share some thoughts on the subject.

Broadly speaking, I would essentially define a financial asset bubble as a case where the price of an asset has far outstripped any reasonable relationship to what it should be priced off of. With stocks, this is the earnings power of a company. With housing, it is the price to rent ratio or a price to income ratio with some adjustments. Asset prices, no matter how much people may want to believe otherwise, must necessarily be constrained by their relationships to their fundamentals over long periods of time. If this was not a constraint, we could all become infinitely wealthy by speculating in financial assets. What these fundamental relationships should be (i.e. a PE of 15x vs 17x or a price to rent ratio of 1.1x 1.0x) are the province of markets to flesh out over any given time, but in the long run, certain reasonable relationships do hold.

"Ah", you might say, "You said in the 'long run'. What about the short run where I actually live?" Indeed, and this is the problem. Over short (3-5 year time spans) any particular asset class can become wildly overpriced. How wildly? Well, let's look at the NASDAQ in the span of 1996-2000:

As you can see, up until 1999, the NASDAQ held more or less in line with the S&P 500 before wildly departing and going absolutely bonkers (technical term). What's more is that the S&P 500 in this time frame was also overvalued quite considerably, though I will discuss that finer point in detail in later post. Earnings growth during this time span was good, especially for the technology-heavy NASDAQ, but not anywhere near that good. It's much like how ordering pasta at a high-end Italian restaurant may be worth $15.00 a plate, but not $30.00. At $30.00, you are just being irrational.

This takes me to a brief digression on economists. Many economists, particularly those with significant classical leanings (no, they don't sit around and listen to the finest works of Handel, though they might) feel that consumers and investors are always rational and they justify this point with a bit of twisted logic. This is that because an investor bought an asset at a certain price and expects to receive more for it in the future, they are being rational. Only if they bought an asset with the expectation that they would lose money in the future would they be irrational. If this definition of rationality strikes you as absurd, it should. If I were insane and kept drinking six cans of Dr. Pepper everyday under the expectation that would be good for my health, would that be rational? Well, it might be if I were poorly informed, but I would already have to be irrational to believe such a thing.

This brings me to how to, qualitatively, spot a bubble. You do not do so by saying "Oh, the stock market is up 50% over the past twelve months so that must be a bubble" because the market has done that plenty of times and not looked back ever again. Similarly, in individual sectors, a rapid advance does not necessarily mean that people are not in league with their senses. Steel production in the United States in the late 19th century increased many thousands of percent and did not constitute a bubble. Similarly, PC sales from 1985 to 1995 increased by such a large percent that most people wouldn't believe it if you printed it. As such, a simple quantitative rule such as "x% increase necessarily equates a bubble" is not useful.

The basic qualitative framework for assessing the likelihood of a bubble is trying to determine the amount of reliable information (broadly construed) available in a market and then assess to what extent that information is being employed rationally. There is a third variable that is unfortunately quantitative, but is easily enough assessed which is whether the asset or whole asset class in question present offer greater than typical rates of return. Bubbles do not form in assets or asset classes where there is not a truly better than typical fundamental story going on. For example, the U.S. housing bubble formed during a time of low inventories and high affordability due to low interest rates. The NASDAQ bubble occurred in the sector of the economy seeing the fastest growth.

So, to put succinctly:
1. Is the asset or asset class in question fundamentally more attractive than other alternatives?
2. Is there either little information available or is the information corrupted in some way?
3. Are market actors incorporating available information or are they doing so in a rational way?

As I hope to show in later posts, this basic framework can be used to assess not only the presence of bubbles, but also to determine the differential effects of bubbles within an asset class. Incidentally, these criteria can be used to assess what I call "fear bubbles" such as what existed in March 2009.

A Nervous Eye Toward the (Far) East

Technically Europe is a closer east than Asia is, but I will conform to the conventional parlance on this one. In any case, while the concerns around Europe are well known, I have been more closely tracking the troubling developments in the property markets in both mainland China as well as Hong Kong, and I don't like what I see. 

From this Bloomberg article on Hong Kong: 
"Home prices have risen 41 percent since the end of 2008, prompting the government to tighten down-payment requirements for luxury homes in October to curtail speculation after record- low interest rates fueled the surge. Financial Secretary John Tsang on May 12 pledged to keep boosting land supply."


Home prices up 41% in 16 months? That's worrisome to say the least. Considering that in the long run home prices are a function of incomes, I find that a little odd. I suspect that there are some at the upper ends of the income strata in Hong Kong that have seen even greater than 41% income growth and that is probably what is propelling prices higher at the margins. However, just as in California five years ago, the super rich are never enough to support a large real estate market (and despite being only one city, Hong Kong is a large market). Eventually, California reached a point where 88% of the population could not afford the median house. Yes, that is just as silly as it sounds. Hong Kong is at a similar juncture right now. Prices will have to correct, the question is when.

Weekend Reading: Bonds a Bubble?

There has been a fairly consistent refrain for two years or even longer that treasuries may indeed be overpriced, meaning that interest rates are consequently too low on long term instruments. This interesting article from MarketWatch hits on this idea yet again.

One thing worth considering is what it would mean if the long term treasury market actually did go bust. What are the implications for your investments? Unfortunately, this is not a pleasant prospect and it leads to one wondering where exactly their money should go. I actually don't have any particularly firm answers on this front, to be quite honest, but maybe by talking it through we can uncover some possibilities.

So, let's just say for a moment that for one reason or another, long term bond prices suddenly collapse. This could be because of worries about the solvency of the U.S., suddenly higher inflation expectations, or much more attractive investments elsewhere. The last two are more like than the first. Basically, if investors either need to abandon the safety of treasuries to beat inflation or if they feel that other markets offer stable enough returns that they can leave their fortress of U.S. treasuries, bonds will rout. How vulnerable are bond prices to changes in long term interest rates? Well, if rates on the 10-year rose from 3.30% to 5.00%, a $1,000 investment in treasuries would turn into $866.86. Ouch.