Monday, June 29, 2009

Investment, Speculation, and Bubbles

Investors invest on a value basis for the long term. They try to determine what an investment is worth and value investments according to the income they expect. Speculators invest on a momentum basis for the short term. They try to determine what others think an investment will be worth and value investments according to the gain they expect. These are caricatures somewhat as many will consider themselves investors only to turn into or be turned into speculators after the market moves against them.

During a bubble there is a transition from assessing value to assessing other peoples assessment of value recursively providing convergence in expectations and a positive feedback loop for the explosion of prices. Eventually it runs short of new money or participants. Price increases start falling short of expectations. Speculators are forced out or start selling out. Prices start to fall. Expectations change. Feedback turns negative resulting in an implosion of prices.

In no place was the difference clearer than the housing bubble. Incomes never grew through it. The Fed has largely come to define income growth as inflationary and stemmed any real increase in it so no one should expect rapidly rising incomes. There was no investment case for housing in general. Lower interest rates meant property prices would increase, but also meant if they rose, prices would decrease. They could only always be worth more if one expected interest rates to keep falling. That is quite hard to swallow. The reason prices rose was because speculators were investing on a momentum basis and the reason they fell is because they were disinvesting whether due to being unable to carry them or on the same basis.

Under efficient markets, price is value, bubbles don't exist, and none of this makes sense, but to make sense of efficient markets one has to theorize investors had expectations prices would continue to rise, but how could prices rise without incomes to support them? Did they really believe the Fed would inflate to keep prices heading up after 20 years of disinflation? Could they really believe interest rates had only one way to go, even after the Fed began raising rates? Efficient markets strain credulity the same way lending standards strained credulity during the bubble. The only way to make sense of it is to assume limited rationality that makes momentum speculation reasonable. The only problem with that is it undermines and makes a mockery of efficient markets.

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