The animal spirits are stirring again in the markets as the asset management industry grows to a record level and shrugs off some of the debilitating effects of the financial crisis. ... The amount of money invested globally by asset managers has for the first time surpassed the highs before the 2007-08 crisis, according to Boston Consulting Group, the management consultants. ... Gary Shub, partner at BCG, agreed that animal spirits, a term used by economist John Maynard Keynes to describe positive actions because of instinctive optimism, had recovered in the markets, although he warned it was not a fully fledged revival.
Market bubbles are called bubbles for good reason. They form, they inflate, they grow to an unstably distorted size, and ultimately they undergo the effects of rapid decompression in search of equilibrium. In a word … they pop. And generally speaking, the bigger the bubble the bigger the bang. … Most of us are pretty good by now, we think, at spotting bubbles. After all, we know what they look like; we recognize their characteristics, don’t we? Maybe. Maybe not. Not all bubbles look or act the same. … Is there a bubble inflating again? … people often shrug their shoulders, scratch their heads, and simply accept that there must be good reasons why stocks have been on a roll. The average investor, after all, is at least one step removed from the markets for intangible assets and therefore has comparatively little experience to help avoid becoming their occasional Venus flytrap dinner. … When it comes to assessing the state of the real economy, on the other hand, most people are more circumspect and not so easily taken in. … this bubble was born of desperation, first by the misguided monetary policy regime and then by investors who are sure to become its unsuspecting victims as they look for return—any return—in all the wrong places. … Railing against Fed policy, of course, doesn’t change it. … we continue to believe it is possible—and necessary—to see both the forest and the trees in order to fulfill our highest obligation: to continue acting in the best interests of our clients. As noted investment manager Francois Sicart said recently: “The attitude of many professional investors toward the current market makes me think of a crowd enjoying a dance party on top of an active volcano. They know it is going to erupt but, instead of planning an exit, they keep dancing while trying to guess the exact date and time of the eruption.”
In 1948, the behaviorist B.F. Skinner reported an experiment in which pigeons were presented with food at fixed intervals, with no relationship to any given pigeon’s behavior. Despite that lack of relationship, most of the pigeons developed distinct superstitious rituals and maneuvers, apparently believing that these actions resulted in food. As Skinner reported, “Their appearance as the result of accidental correlations with the presentation of the stimulus is unmistakable.” ... Superstition is a by-product of the search for patterns between events – usually occurring in close proximity. This kind of search for patterns is essential for the continuation of a species, but it also lends itself to false beliefs. As Foster and Kokko (2009) put it, “The inability of individuals – human or otherwise – to assign causal probabilities to all sets of events that occur around them… will often force them to make many incorrect causal associations, in order to establish those that are essential for survival.” ... The ability to infer cause and effect, based on the frequency with which one event co-occurs with some other event, is called “adaptive” or “Bayesian” learning. Humans, pigeons, and many animals have this ability to learn relationships in their world. Still, one thing that separates humans from animals is the ability to evaluate whether there is really any actual mechanistic link between cause and effect. When we stop looking for those links, and believe that one thing causes another because “it just does” – we give up the benefits of human intelligence and exchange them for the reflexive impulses of lemmings, sheep, and pigeons.
Xu had consistently produced returns that were truly unbelievable: His worst-performing fund had grown by nearly 800 percent in five years. He had also survived countless corruption investigations, market falls, purges and other scares. Yet even as his legend grew, Xu remained intensely secretive. ... That equilibrium seemed certain to crumble on June 12, when the Chinese stock market began a free-fall. In the span of three weeks, the market lost a third of its value. ... Unlike in the United States, where institutional investors dominate the market, China’s 200 million mom-and-pop investors make roughly 85 percent of all trades. ... “All these small individual investors are called ‘chives’ in the market,” says Hong Yan, a finance professor at the Shanghai Advanced Institute of Finance. “They get cut over and over again, but they come back every time, like little weeds.” ... By the late 1990s, he became the unofficial captain of a group popularly known as the Ningbo Death Squad. The squad made its reputation by manipulating cheap, relatively unknown stocks, which in the Chinese market are not allowed to rise or fall more than 10 percent in a single trading day. To game the system, the squad devised a strategy: Out of nowhere, it would place a gigantic order for a chosen stock. Other traders, seeing the sudden upward movement in price, would flood in, pushing the stock toward its daily 10-percent limit. Once the stock hit the limit on the first day, the momentum became self-perpetuating. Eager traders rushed to buy the stock as soon as the market opened the next day, propelling it toward the 10-percent limit once again. The movement generated its own publicity and easy profits. After a few days, the squad would sell out, and the stock would tumble back to a lower price as other traders followed. ... “Xu Xiang is always trading,” a longtime friend said. “If he’s not trading, he’s thinking about trading.” ... Nearly every one of the experts I spoke with repeated some version of the same rumor: that Xu was less a financial genius than a puppet of even larger powers. Most often, this explanation was deployed in response to a question that had been troubling observers of the Chinese financial world for months: Why hadn’t Xu stopped earlier? Rumors of his illegal methods were an open secret, and he had already built the most successful hedge fund in China, reaping billions of dollars in personal wealth in the process. Why keep going and risk a reckoning?
In the classical account of a financial market bubble, the price of an asset rises dramatically over the course of a few months or even years, reaching levels that appear to far exceed reasonable valuations of the asset’s future cash flows. These price increases are accompanied by widespread speculation and high trading volume. The bubble eventually ends with a crash, in which prices collapse even more quickly than they rose. Bubble episodes have fascinated economists and historians for centuries (e.g., Mackay 1841, Bagehot 1873, Galbraith 1954, Kindleberger 1978, Shiller 2000), in part because human behavior in bubbles is so hard to explain, and in part because of the devastating side effects of the crash. ... At the heart of the standard historical narratives of bubbles is the concept of extrapolation— the formation of expected returns by investors based on past returns. In these narratives, extrapolators buy assets whose prices have risen because they expect them to keep rising. According to Bagehot (1873), “owners of savings . . . rush into anything that promises speciously, and when they find that these specious investments can be disposed of at a high profit, they rush into them more and more.” ... In this paper, we present a new model of bubbles based on extrapolation. In doing so, we seek to shed light on two key features commonly associated with bubbles. The first is what Kindleberger (1978) called “displacement”—the fact that nearly all bubbles from tulips to South Sea to the 1929 U.S. stock market to the late 1990s internet occur on the back of good fundamental news. ... Second, we would like to explain the crucial fact that bubbles feature very high trading volume (Galbraith 1954, Carlos, Neal, and Wandschneider 2006, Hong and Stein 2007). At first sight, it is not clear how extrapolation can explain this: if, during a bubble, all extrapolators have similarly bullish views, then they would not trade with each other.
The city, with its stunning views of the mountains and yacht-dotted harbor, has long been one of the world’s most expensive places to live but price gains have reached a whole new level of intensity this year. Low interest rates, rising immigration, and a surge of foreign money—particularly from China—have all driven the increases. ... After copious warnings over the last six months, including from the Bank of Canada, that price gains are unsustainable, the provincial government of British Columbia moved last week. Foreign investors will have to pay an additional 15 percent in property-transfer tax as of Aug. 2 and city of Vancouver was given the authority to impose a new tax on empty homes. ... Demand for luxury cars has risen alongside housing prices in Vancouver, with 1,100 high-end vehicles on the streets of Vancouver as of Dec. 31, 2015, almost double the 2009 count, according to the Insurance Corporation of British Columbia.
Well, the word “behavioral” refers to the introduction of other social sciences into economics: psychology, sociology, and political science. It’s a revolution in economics that has taken place over the past 20 years or so. It’s bringing economics into a broader appreciation of reality. Economics was more behavioral 50 or 100 years ago. At Yale University, where I work, 1931 was the year when the department of economics, sociology, and government was split into three separate departments. ... There are both advantages and disadvantages of this structure. The advantage is that we develop mathematical economics and mathematical finance to a very advanced level — and that’s useful: We have option pricing theory that is very subtle and allows complex calculations that have some relevance to understanding these markets. But it loses perspective on why we have these options anyway. It offers a justification typically that involves rational behavior. ... We tend to look for patterns in the data that we think are representative of history. ... in the economics profession of 20 years or so ago, there were no bubbles. Now people freely say “bubbles,” but it was one of those words that was considered unprofessional by economists because markets are smarter than any of us and anything that happens in the market has a rational explanation.
Since I’ve written so many cautionary memos, you might conclude that I’m just a born worrier who eventually is made to be right by the operation of the cycle, as is inevitable given enough time. I absolutely cannot disprove that interpretation. But my response would be that it’s essential to take note when sentiment (and thus market behavior) crosses into too-bullish territory, even though we know rising trends may well roll on for some time, and thus that such warnings are often premature. I think it’s better to turn cautious too soon (and thus perhaps underperform for a while) rather than too late, after the downslide has begun, making it hard to trim risk, achieve exits and cut losses. ... Since I’m convinced “they” are at it again – engaging in willing risk-taking, funding risky deals and creating risky market conditions – it’s time for yet another cautionary memo. Too soon? I hope so; we’d rather make money for our clients in the next year or two than see the kind of bust that gives rise to bargains. (We all want there to be bargains, but no one’s eager to endure the price declines that create them.) Since we never know when risky behavior will bring on a market correction, I’m going to issue a warning today rather than wait until one is upon us.
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