The Psychology of Asset Cycles

Posted by jeff

Wed Sep 12th, 2007 08:57 AM

Back in May no one was too worried about several trends that were bothering me and I cited an old Wall Street maxim that "its the stuff no one is worried about that kills you". At the time the housing bubble popping was well known and Chairman Bernanke of the Fed, Treasury Secretary Henry Paulson and the CEO of Bank of America had all recently commented that the housing downturn was, bottoming, petering out etc. Silly me. I didn't even mention the housing downturn in my piece "Black Monday 20 Years Later: What Me Worry?".


I was more concerned about the toppy buyout boom (recall Noah's post in July on "Buyout Boom Brings Reason To Worry"), slowing profit growth, productivity declines, a weak dollar and bond market, and general debt levels. But what was really bugging me was psychology, overall and the lack of anyone seeing the parallels to 1987 including a flurry of insider trading, other countries "diversifying away from our government bonds" (add Japan to this list as of last week) and seminal top marking type deals like the Blackstone IPO. As the sub prime debacle has been playing out I have been quiet in terms of submissions to the site. For one thing, I have found that it's a losers game to make sweeping calls in the midst of a market crisis, because you lose credibility. In 5 minutes everything can change and you look like a knucklhead. Secondly, my research has been focused outside of the Manhattan real estate market lately and since I don't personally have the warm and fuzzies on real estate generally, right now I don't want anyone thinking I am touting any particular neighborhood as immune from what may be coming to the Big Apple. OK sorry for the pre-amble. Forget what's happening today in the markets and forget about data - there will be none in my piece - lets talk about the psychology of market cycles.

In the beginning people hate a certain asset because they were burned by a horrific decline. Think tech stocks in 2003, real estate in 1993, oil in 1998.


The bottom is usually struck with some major publication saying the asset will never recover. The Economist proclaimed "Drowning in Oil" on its cover in early March 1999. If you bet everything you had on Black Gold that day, your rich and retired (not that I would have advised that). Paul McCrae Montgomery, president of Montgomery Capital Management invented the Magazine Cover Indicator after studying its correlation with peaks in markets. His premise was that by the time a major investment trend makes it to a magazine cover the best money has already been made. Interestingly it seems to mark bottoms pretty well. Newsweek magazine marked the bottom of the late 1980's / early 1990's collapse in the real estate market with its October 1990 cover, "The Real Estate Bust,". Interestingly, in a 2005 interview McCrea avered that magazine covers proclaiming the golden age of residential real estate, were not signaling a bust because Wall Street had not already over-exploited the trend as it usually does. Little did he know - but I'm getting ahead of myself.


The next part of the market cycle is the low risk high return phase. This is when the asset, which had grown above trend line growth, then suffered several years of below trend line growth, accelerates back to normal or slightly above normal growth. Say for example the normal rate of telecom equipment spending growth is 5% per year but it goes to 15% for 3 or 4 years, then its negative 20% to 30% for a couple of years, but finally recovers to 7% to play catch up. This is the best part of the cycle for investors and many miss it because they still hate the asset. Now things normalize for a while, which could be 5 to 20 years. It took ten years for oil to kind of stabilize after the 1980s debacle. Residential housing didn't start to get hot until the very late 90s after peaking in the late 80s. These long rest periods are important because many people who were around and had direct experience of the asset crashing leave the business, retire or die of boredom. Next things start to get rocking due to some new big catalyst like China turning commodities (what was viewed as the biggest losers game in creation) into the next big thing. As the rocking turns to rolling, trend following investor types start to get involved - unfortunately this usually includes the individual investor who invariably gets burned.


The people doing acquisitions, and supplying credit to the industry/asset class start to relax their standards because they see a positive trend in place and they begin to impute it into their forecasts and behaviors. Competition heats up and if you insist on being a naysayer about the industry's prospects you lose market share and get left behind or fired. The industry grows and lots of newbies join, they have never seen a down cycle and all they see is naysayers getting left in the dust. Those who leverage up the most and take the most audacious buying real estate in Harlem in 1995 make the highest returns. These winners become very confident and they consume conspicuously.


The money appears so easy to make that fraudsters start to get involved....I mean out and out larcenous criminals. Remember when the mafia got into starting penny stock bucket can't make this stuff up. During the dot com bubble a 15 year old boy named Jonathan Lebed bought penny stocks, then pumped them up using messages on chat boards, until he was busted by the SEC. Unfortunately, people who were otherwise honest in their careers, really don't want to or need to be criminals also become swept up in "institutional crime". This is the crime with no perpetrator....the mortgage company that invents a financial weapon of mass destruction because it can, it sells it to old retired ladies whose diabetes medicine cost increases are making their fixed retirement income tight and they end up refi'ing their way into oblivion. Some goober on Wall Street buys this paper because Moody's tells him its okay. His boss is watching his performance versus the other goober bond managers daily and if he dosn't buy this paper his competitor will and will beat him by taking more risk. Al Harrison, a well respected portfolio manager at one of the country's top mutual funds was buying Enron hand over fist, even after the CEO jumped ship.


The savviest market players start to talk about how hard it is to find good deals in the market, but when asked what they are doing they say BUYING. (Six months ago I went to a panel on commercial real estate....not residential....and heard the same thing. More on this in another post). In March of 2000 when the last spike of the tech stock bubble took place it was being widely circulated in the market that after sitting out the entire mania, the master himself George Soros was throwing in the towel and "buyin em".


One day something happens and the market for the asset starts to soften - that thing is almost always - The Fed Raising Rates. You can cite overbuilding of fiber optics, OPEC violating quotas on oil pumping or anything else you like for asset price downturns, but all this overbuilding stuff can continue for long periods of time until The Fed Raises Rates. It's because stealthily firms are creating more and more credit to keep the asset rising, whether it be Cisco, Nortel and Lucent making loans to their customers Winstar and Level Three (anyone remember these names if you did you probably lost money in them) to buy their equipment or mortgage companies coming out with 10/1/10 Interest only Option ARM cash out refi leveraged reverse amortizing blow your head off loans.


As the asset rolls over, the ripple effect of the tide going out starts. This is the part where you get to see "Whose Swimming Naked" and has hidden bets. It could be a hedge fund like Amaranth who was supposed to be diversified, but had a massive bet on Natural Gas prices so large regulators would have forbid it if they knew about it (but it was done through an online market outside their ken) or a European bank which was making big fees running an off-balance sheet conduit that borrows short, lends long and is leveraged....OUCH.


At this point in the cycle a crisis of confidence hits. Everyone knows that there are other players holding "The Old Maid" but they don't know how big or bad she is, or how many are out there. So they are very reluctant to even play the game. This is what happened in August folks, and when the gears stop turning the Fed steps in. The Fed can help grease the skids and eventually if needed they will bring out the big guns of liquidity if necessary, but they can't stop the inevitable unwinding of the asset and the damage to players. (FYI I totally agree with Noah there ain't no way they gonna cut rates with no data showing a slow down...and if they do...get worried.) In 1998, the Fed bailed out Long Term Capital to prevent the gears of financial commerce from grinding to a halt and the US did fine. But it didn't stop the destruction of wealth in foreign countries where the excesses were. I digress.


The last phase of the saga is the closing of the barn door. This happens of course when the horse is in the next county and wreaking havoc there. The great legislators of our country wake up to the fact that an asset bubble caused misbehavior intentional and unintentional and they create laws to protect the populous from this ever happening again. That's why bubbles move from market to market they stay away from areas people remember getting burned in before and areas where legislation impedes the bubble-ization process. Importantly, these laws make the pain in the asset worse and really put the nail in the coffin. Whereas before you could borrow to your heart's content to leverage an asset, the new rules significantly impede the ability to do this, making the asset less profitable to play in, so more people sell it. The related professions that were supposed to have some watchdog function in the industry that failed, like bond rating agencies and real estate appraisers get tarred as criminals. These professions which no one really understands but maybe has some distant relative who works in, become household names. These folks who were just doing their jobs become pariahs due to inherent conflicts of interest that had always existed in their jobs, but became problematic due to the bubble.


In past bubbles insurance agents, accounting firms and their consulting arms, Wall Street equity analysts and others have all taken the heat. Unfortunately, as a result these industry experts turn acutely conservative and become deal killers rather than deal enablers this makes dealing in the asset even harder and is the Coupe De Grace that makes the market hate the asset and avoid it until the next cycle begins.

I love data and I like to know The Numbahs. But in some cases you need to ignore the data, which is by nature backward looking and usually of only short-term import and just stand back and listen to what the crowd sounds like. History doesn't repeat itself but it rhymes. Re-read the bold phrases in this article and in addition to evaluating the data watch for these sign posts when you are assessing where you are in the cycle of any asset class.


Just a little epilogue. Indicators like the magazine cover indicator are obviously fallible they tend to correlate with tops and bottoms they don't cause them, but they give an indication of the psychology which is necessary at turning points. For many years fashion has been gyrating more feverishly than in decades past and has generally been on a trend of getting more risk-ay. As a result an old indicator called the hemline indicator stopped getting much play, despite being prescient to 1998's stock market shellacking. In eras gone by it was believed that when hemlines rose and fashion got more risky markets rose and that when hemlines became more conservative so did investors. The word out of Fashion Week hear in Manhattan....Look out below...the knee that is.