Don’t Catch Falling Knives

During the collapse of the dot.com bubble, I believed that the stock of the company I'd founded, ITXC, was grossly undervalued; so I bought some both hoping to profit and also to calm the market by showing investors that I was willing to risk my own money in the stock – when CEOs buy it's public information. I may have calmed the market for about five minutes. Buybacks by cash-rich companies have some good purposes – but they won't stop a bubble bursting, either. I also tried to convince the investment bankers who bought us public to invest in the stock of company they recommended. "We won't try to catch a falling knife," one of the bankers said rather unkindly. Ironically, the bank was Lehman, one of the few big financial knives the government didn't try to catch.

When we had a rapid deflation of the dot.com bubble and dot.com stock prices, the damage was contained because margin rules are fairly strict and people did not have loans for 100% of what the stock cost. The restriction on what percentage you can borrow of the value of a stock you want to buy (it's called "margin" if you've never indulged) was a reform enacted after the Great Depression because the stock market collapse of 1929 was intensified by lenders calling for repayment of underwater margin loans. The 1929 stock market collapse also spread more quickly and more severely to the general economy than the dot.com collapse did, arguably because so many people on Main Street had 100% margin loans.

It took until recently for the "margin requirement" on houses to go to zero, for people to be able to buy a house for nothing down. The first result of making loans for a particular kind of asset easy to get is that the price of the asset goes up because more people can obtain the cash to buy it (note that I did NOT say that more people can AFFORD it). In this case Fannie Mae and Freddie Mac with plenty of help from the real private sector and encouragement from Congress in essence created a special currency that could be used only to buy houses. Surprise, houses inflated faster than almost any other asset. The Wall Street Journal to its credit has been pointing this out for years. The New York Times ran an expose the other day – better late than never; it is well done.

For a while bubbles are self-inflating because people who get in early get rich. More real money comes into whatever asset class (stock, houses, oil, etc.) is appreciating quickly so, of course, the appreciation accelerates and attracts yet more money. But trees can't grow to the sky. Money leaks out of the asset class, too. In the case of houses there are realtor fees but that's small change. More importantly huge amounts got diverted to compensation for those who managed the flow of creative financing AND people took out home equity loans based on the inflated values of their houses and spent these loans for non-housing purposes. In the dot.com bubble, there were also high financing fees, employees exercising options and immediately selling, and founders and VCs cashing out.

Moreover, the supply of a bubble asset class is bound to increase whether the asset is houses, stock in dot.com companies, or tulip bulbs.

Once the supply increases sufficiently and the outflow of cash from the asset class exceeds the inflow, pop goes the bubble! Always happens but no one knows when.

In the early stages of a bubble bursting, almost everyone expects the assets to recover to the value they had at the top of the bubble – almost everyone waits too long to sell because they are betting on "recovery". But, since the assets were overvalued at the top, that's not what the price is recovering to; the price is moving back to what it would have been if there's never been a bubble. That's why it's premature to look for a housing recovery now. There are also always attempts to "calm the market" in the hopes that nothing is wrong other than a gust of fear. We're seeing that now with many calls to support the price of houses. But, if the asset was grossly overpriced and a bubble is bursting, money spent on calming will disappear as if it were thrown into a black hole.

The deflation of a bubble bursting gains momentum just like the original inflation. If the assets were purchased with debt – and they almost always are during a bubble because leverage increases profits, once the price falls far enough, owners of the assets have to sell in order to pay off their loans. The supply of asset for sale increases as money available to buy the asset class decreases. The price goes down through whatever it would have been had there been no bubble. Eventually, of course, that sets the stage for a recovery if not another bubble. The recovery, like the collapse, always happens later than it rationally should; and no one knows when that will be. Buy before the overshoot on the downside and you're catching a falling knife.

 

Comments

[ellen]

I see this more in consumer terms. You take a handbag made of vinyl and leather and the cost to make it is $20. You add a bit of branding and retail it for $1000. Most people see it on sale for $500 and think WOW what a bargain, but it is all a facade. The handbag is still only worth $20 but the perceived value has been what has counted these last few yrs. When you try to resell it without all the fluff of branding it is nothing more than a bit of leather and a whole lot of vinyl, practically worthless.

[Steve Layne]

Hey Tom.....great commentary...... Warren Buffet said it well last week,

In all Bubbles they start with Innovators, then come the imitators, then the idiots!

As you know, us innovators can easily become idiots simply based on our deep belief of our innovations! I mean, who turns their backs on their kids? Especially in times of distress..... Well we now know the answer to that question, the Investment Bankers!

Hope all is well.....enjoying your posts via FB....

Steve