The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (3 page)

Now, to be fair, the $1 trillion federal debt in 1982 really wasn’t that much compared to today’s nearly $16 trillion federal debt, but the relatively small annual federal budget deficits in the 1980s were significant because they were the early beginnings of the big federal borrowing and big deficit spending that would come later.

Of course, at the time, no one was too worried about the beginnings of big federal borrowing and deficit spending in the 1980s. In fact, the U.S. economy grew nicely over the next couple of decades, with a 260 percent increase in U.S. gross domestic product (GDP) from 1980 to 2000. And asset values, such as stocks, bonds, and real estate grew even faster.

However, there was a hidden driver behind much of this rapidly rising abundance:
bubbles
!

This should be a relatively easy question to answer, but, believe it or not, there is no academically accepted definition of a financial or economic bubble. For our purposes, we define a bubble as an asset value that temporarily rises and eventually falls, primarily due to changing investor psychology rather than due to underlying, fundamental economic drivers that are sustainable over time.

Before it is a bubble, an asset value may first begin to rise because of real fundamental economic drivers, such as when population growth pushes up the demand for housing and therefore the price. But at some point, the impact of the underlying fundamental driver has a diminishing effect and hopeful investor psychology takes over, pushing the asset value temporarily higher, creating a bubble.

In the course of history, asset bubbles have varied greatly in their causes, duration, height, and crash impact, but one thing has remained absolutely constant about all bubbles of every type and size:
they all eventually pop
. By definition, if it is a bubble, what goes up must come down. That is the economic reality that no bubble can escape.
Gravity happens
. It’s only a matter of time.

Because bubbles go up primarily due to investor psychology rather than due to fundamental economic drivers, all it takes for a bubble to fall is a significant enough change in investor psychology. What makes investor psychology change significantly? Investor psychology changes when enough people figure out that they have bought into a bubble, leading to a sell-off and a bubble pop. If it weren’t really a bubble, the deep sell-off wouldn’t last. Nonbubble asset values can certainly drop, but the underlying fundamental economic drivers would still be in place and eventually investors would soon return to buy back the asset, stopping its fall. Only bubbles pop; nonbubbles may fall but eventually recover.

Is it possible to stop a bubble from falling or to reinflate it once it falls? The short answer is no. You cannot indefinitely prevent a popping bubble from popping, nor can you push it back up and keep it up once it fully pops.

However, the longer, more nuanced answer is yes and no. While we can’t permanently prevent a bubble from popping, we can
delay
it from falling and even push it back up a bit with a lot of resources and artificial stimulus. As we will see later in this chapter, that is only temporary and often leads to a much bigger bubble crash down the road.

Why doesn’t artificial stimulus work to
permanently
reinflate a bubble? Because, generally speaking, you cannot fool the same people twice, and even when you can fool the same people twice, you cannot fool them for as long. For example, if you were among the investors who lost money when the Internet bubble popped, how willing have you been since then to buy stock in technology companies that show no profits? Investors do generally learn and move on.

However, with massive amounts of artificial stimulus (like massive money printing by the Federal Reserve), it is possible for a falling bubble to defy gravity and temporarily rise again. But because of the enormous costs, massive stimulus cannot continue forever. Eventually, the stimulus has to stop and gravity wins. So, for various reasons, including artificial stimulus, a popping bubble may not go down in a straight line. Instead, it may pause in its descent or even lift up for a while, but in the end
down
is its destiny.

How can we know if an asset value is rising primarily due to positive investor psychology (speculation leading to a bubble), rather than due to underlying, fundamental economic drivers that are sustainable over time (real growth)?

While it is not always easy, it is possible to analyze and identify a not-yet-popped bubble if you are willing to stay rational and objective, and not get caught up in wishful thinking. It is human nature to want to believe in a rising bubble, especially when it is a bubble that you profit from or depend on. The only way to see a bubble that has not yet fully popped is to make a firm commitment to clear-eyed logic.
You cannot stay asleep with the sheep
.

As we pointed out in our earlier books, there are two important truths about bubbles.

Bubbles Are a Lot Easier to See
After
They Pop

and

The Hardest Bubble to See Is the One You’re In

Throughout the ages, asset bubbles have always been largely invisible right up until the end. For example, no one could see the Dutch tulip bubble before it popped in 1637. Virtually no one saw through the appealing South Seas stock bubble until it burst in 1720. Investors were not the least bit worried about the great Florida land boom in the 1920s until the property values crashed back to earth, just as few people concerned themselves about the intoxicating stock market boom of the 1920s until it evaporated into the crash of 1929 and the Great Depression. And more recently, precious few investors and analysts recognized the irrational exuberance of the Internet stock bubble in time to get out before it popped in 2000.

Looking back, these examples of past bubble booms and busts seem so obvious now, don’t they? Of course, it makes no logical sense to overpay for tulips, buy swamp land in Florida, or invest in dot-com companies with no profits, but at the time, all these seemed perfectly plausible, even desirable to investors. Regardless of the time, place, or type of asset in question, all bubbles share this common feature: positive investor psychology pushes the bubble up, and negative investor psychology pushes the bubble down.

Here is the typical bubble-up, then bubble-down pattern:

• An asset value begins to rise due to some underlying, real economic drivers that begin to boost demand and therefore the price.
  
• As the asset value begins to rise, investor psychology begins to rise as well, leading to some investor speculation about the future value of the asset.
  
• Investors become even more interested in owning the rising asset, pushing up the price.
  
• More and more investors take notice and want to buy in before the asset price rises even further.
  
• As the bubble approaches its peak, some investors become anxious about future growth and sustainability, which leads some investors to increase their profit taking (selling the asset).
  
• Other investors take notice and become anxious or at least do not feel as positive about owning the asset, also deciding to sell.
  
• The asset price no longer rises and begins to decline.
  
• Positive investor psychology is increasingly replaced with neutral or negative investor psychology, sparking a larger sell-off.
  
• A critical level of negative investor psychology is reached, a mass exit begins, and the bubble pops.
  
• Most people cannot exit quickly enough and most of their assets go to Money Heaven.
  

After the fact, it all seems so terribly obvious, doesn’t it? However, this pattern is anything but easy to recognize
before
a bubble pops. Not-yet-popped bubbles are amazingly difficult to see. Why? Because we don’t want to see them! We want the big run-up in prices to be real and sustainable, not a bubble. It takes a firm commitment to logic to see a bubble before it pops.

Now let’s take a clear-eyed look at our current bubbles, the ones that have been working together to help push up the U.S. economy over many years, and more recently have started to deflate and lean heavily on each other, helping to push down the falling U.S. economy as they pop.

The U.S. economy has been such a strong and prosperous powerhouse for so long, it’s difficult to imagine anything else. Our goal is not to convince you of anything you wouldn’t conclude for yourself, if you had the right facts. Most people don’t get the right facts because most financial analysis today is based on preconceived ideas about a hoped-for positive outcome. People want analysis that says the economy will improve in the future, not get worse. So they look for ways to create that analysis, drawing on outdated and incorrect ideas, such as repeating “market cycles,” to support their case. Such is human nature. We all naturally prefer a future that is better than the past, and luckily for many Americans, that is what we have enjoyed for many years.

Up until a few decades ago, we grew our rising economic prosperity the old-fashioned way: by increasing real productivity. We laid railroad track from coast to coast that led to an explosion of trade. We invented cars and airplanes that changed how we lived and did business, and that impacted economies around the world. It wasn’t all perfect, but rising productivity growth worked like Miracle-Gro on the rising U.S. economy.

Then something changed. Instead of rising productivity growth, real productivity growth began to slow down in the 1970s. In addition to declining productivity growth (and perhaps in some ways because of it), we also began to borrow massive amounts of money. Please do not waste precious time assigning political blame. Over the years, presidents and congressional leaders from both parties participated in this orgy of borrowing and deficit spending. Love or hate what we spent the money on, the fact is we have been borrowing and spending a whole lot of OPM (other people’s money) since the early 1980s.

And please don’t just blame the politicians. All this public borrowing and spending by governments was accompanied by plenty of private borrowing and spending by businesses and consumers. Plus, there were plenty of investments in what would eventually become asset bubbles, all combining to give us what we call America’s Bubble Economy (spurring us to publish a book by that name in 2006).

To quickly review, we identified six colinked, economy-boosting bubbles that together helped boost the rising multibubble economy in the 1980s and 1990s. Since 2006 (with the popping of the real estate bubble), these bubbles have been deflating and falling, each putting increasing downward pressure on the others. These are . . .

Now that it is partially popped, the real estate bubble is easy to see. As shown in
Figure 1.1
, from 2000 to 2006, home prices grew almost 100 percent.

Figure 1.1
Income Growth versus Housing Price Growth 2001–2006

Contrary to what some experts say, the earlier rapid growth of housing prices was not driven by rising wage and salary income. In fact, from 2001 to 2006, housing price growth far exceeded income growth.

Source
: Bureau of Labor Statistics and the S&P/Case-Shiller Home Price Index.

If nothing else, looking at
Figure 1.2
on inflation-adjusted housing prices since 1890, created by Yale economist Robert Shiller, should make anyone suspicious that there was a very big real estate bubble in the making. Note that home prices barely rose on an inflation-adjusted basis until the 1980s and then just exploded in 2001.

Figure 1.2
Price of Homes Adjusted for Inflation Since 1890

Contrary to popular belief, housing prices do not ordinarily rise rapidly. In fact, until recently, inflation-adjusted home prices haven’t increased that significantly, but then they just exploded after 2001 (1890 index equals 100).

Source: Irrational Exuberance
, Second Edition, 2006, by Robert J. Shiller.