31 Mar CNBC: Bullish on Books
(originally posted to CNBC.com March 2011; http://www.cnbc.com/id/42343583)
Spotting Bubbles Before They Burst
Financial booms and busts are, particularly from an a priori perspective, probabilistic events for which multidisciplinary analysis is essential. Addressing financial booms and busts through a single lens may in fact have negative impacts and lead to gross misunderstandings.
Adopting a singular perspective will lead to an emphasis on depth of data versus breadth of information. It leads to deeper and more thorough understanding of particular information, but it misses the point that information is not the essential element.
There are plenty of “dots” but the connections between them are lacking.
Conceiving of financial booms and busts as uncertain ambiguities necessitates the application of different lenses to develop a probabilistic interpretation of scenarios to better understand how they may evolve. Economists, political scientists, psychologists, and even hard scientists have much to learn from each other. What we need today are analysts who employ a multidisciplinary perspective to connect the dots.
With this in mind, I designed a course to teach such a methodology about three years ago. Since 2009, I have taught this course at Yale University to undergraduates studying economics, psychology, political science, art history, American studies, history, East Asian studies, English, physics, and even molecular biochemistry and biophysics. Last fall, my class comprised students from Singapore, Greece, China, India, and several other countries.
The class is structured in three parts.
The first presents several theoretical lenses that have proven useful over time in the study of booms and busts.
These lenses include microeconomics, macroeconomics, psychology, politics, and biology. The second part then applies these lenses to historical booms and busts ranging from Tulipomania to the current crisis, and the final section asks students to develop a framework for identifying bubbles before they burst. The final class is focused on student presentations of current bubbles, with an emphasis on the believability of their story.
To help students focus on moving beyond the ivory tower, I invite a market commentator or working professional to serve as the “bubble judge” and to help me grade their presentations. Past judges have included David Swensen from the Yale Investments Office and Jim Grant from Grant’s Interest Rate Observer.
These presentations are a highlight of the course, and serve as wonderful insight into what those with fresh eyes and free of Wall Street propaganda think are likely bubbles. So, what looks bubbly to those trained to use multiple lenses?
1) China, or more specifically, Chinese property. A handful of students suggested that the real estate boom in China appeared unsustainable. The rise of organized “speculator groups” was noted alongside rapidly rising credit levels, lofty property valuations (relative to income), and a forthcoming explosion in inventory levels.
2) Gold. Described by several students as the “ultimate greater fool” asset, the bubbly nature was also evident in student analysis of financial innovation (ETFs, leveraged ETFs, etc.) that has helped increase amateur investor participation. Ubiquitous commercials about buying and selling gold provided further support for their case.
3) Credit. Highlighting that US Treasuries were trading at historically low yields, or that municipal bonds seemed to be trading on a “too big to fail” assumption, students noted that the universal belief that moral hazard and extrapolation of past trends were likely to create “return-free risk.”
4) Social Networking. A group of my students in 2009 highlighted that the lack of appropriate valuation anchors enabled an Internet-era like approach to pricing these assets. Parallels were drawn with other historical innovations (canals, railways, telegraph, radio, automobiles, etc.) and the fancy valuations received by “new era” companies.
5) Emerging Markets. The universal belief that emerging markets were the sole source of growth in the world today led various students to suggest that the scarcity of believable growth stories would drive emerging markets to unsustainable levels. Within this theme, negative real rates were considered a culprit and one that would eventually be addressed through restrictive policies. India was highlighted as particularly expensive and vulnerable to this inflation-driven tightening.
Numerous other ideas have arisen, many of which appear to have well-analyzed, believable logics to them, ranging from the rare earth mining industry (multi-billion dollar valuations with little financial support), alternative energies (change the world, new era beliefs), and even garlic (medicinal purposes rising, Chinese demand, etc.).
To date, the multi-disciplinary framework developed in the class has proven useful on numerous fronts. It has helped those adopting it to take a step back and acknowledge that the bark they have studied is a part of a tree, and that the tree is in a forest…and most importantly, it creates a healthy skepticism of the alluring and seductive “it’s different this time” rationalizations which can be so hazardous to one’s wealth.