savageinfidel

My previous two posts make it clear that all the conditions are in place for a bond bubble: strong fundamentals, technical momentum, and a mechanism for positive feedback. But these conditions are merely necessary; they are not in themselves sufficient to generate or identify a bubble. Nonetheless there are certain indicators that suggest we may be entering bubble territory. Let’s start by looking at the fundamentals again. One sign that a market has transitioned from boom to bubble is when the fundamentals change from bullish to bearish, but prices keep rising. I believe that this is true for the bond market. Let’s consider each of the factors I identified in my earlier post , in order: 1. Monetary policy seems to have regressed in recent years. In particular, central banks are no longer strict inflation-targeters; they have become asset-price-targeters instead 1 . Central banks are also less independent than before 2 . Finally, central banks have explicitly moved from tryin...

This is a bit belated - I started it, and then didn't finish before all family got here for the festivities. But better late than never, eh? Here's hoping you all had a Happy Thanksgiving. It's a good exercise to occasionally thing about the things we're thankful for, so here's a few of the things I'm particularly thankful for: My Family - I somehow managed to marry well above my station (the Unknown Wife is far better a person than I deserve, with the exception of her poor taste in spouses), I have a nine year-old daughter who still thinks her dad is pretty cool (I figure I still have another year on that score), and a very good-natured 8 month old baby boy (yeah, I'm too old for this stuff, but it's still pretty cool). My Job - I love being a professor (well, at least most of the time). I spend my workday with smart people, I get to learn interesting things about topics of my choice (they call it research), and teaching is pretty fun. And they ...

There are three types of positive feedback in the market: irrational feedback, rational feedback, and reflexive feedback. To distinguish between these, let me quote a previous post at length: In a bubble, the dominant mechanism is positive feedback; the key to understanding bubbles is understanding this positive feedback. How, then, does positive feedback arise? The most obvious explanation is the conventional one: positive feedback is a consequence of irrationality in the market. And there’s certainly an element of truth in this explanation. Greed, self-delusion, unjustified extrapolation, caring more about relative returns than absolute profits (a.k.a. “keeping up with the Joneses”), conformism (a.k.a. “if everybody else is doing it why can’t we?”), confusing the improbable with the impossible (“house prices will never go down nation-wide”) and other persistent behavioral flaws lead inevitably to bubbles. This has been true throughout the history of speculation. But one doesn’t hav...

In my opinion there are three necessary conditions that have to be in place for a bubble to inflate: fundamentals, technicals, and feedback. Let’s look at each of these in turn. Preceding every bubble there is a boom: a justified increase in prices driven by positive fundamentals . In the aftermath of a bubble, it’s easy to mock the excesses that marked the bubble’s apogee (boo.com! ninja loans!) but all too often people forget the backstory. In fact there were very good macro and micro reasons why the tech sector boomed in the early 90s, and why real estate boomed in the early 00s; it wasn’t all froth. So, have the fundamentals been positive for bonds? I think the answer is yes, they undoubtedly have. Here are some of the factors that have led to lower and more stable interest rates over the last few decades, in no particular order: 1. Improved monetary policy – specifically, central bank independence and inflation targeting – starting with the Volcker Fed 2. The end of the cold...

Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory. So, in the interests of full disclosure, and for what it’s worth: I am not a US citizen or resident, I do not pay US taxes or receive US benefits, I am not currently connected with the US financial industry (except as an external observer and generic investor), and I do not support any US political party. In short, I have no dog in this race . All I want to do is understand what has happened, what is happening, and what will happen, insofar as (and no further than!) it helps me as a trader and investor. And my current unde...

Bubbles fascinate me. Nowhere else will you find such a variegated proving ground for the vagaries of human psychology, nor such a vivid illustration of the wondrous complexity that is the market. The various tensions on display – between individuals and institutions; between incentives and emotions; between rationality and greed; between the short term and the long run; between macro economics and micro behavior; between fundamentals and technicals – offer limitless scope to the curious observer. If the study of markets is the study of human nature, then the study of bubbles is the study of markets in microcosm. My fascination with bubbles will come as no surprise to regular readers of this blog, as evidenced by my choice of subject matter. In recent weeks I have written about bubbles and the rational trader ; scale invariance in bubbles ; feedback effects in bubbles ; the link between asset price bubbles and jobless recoveries ; the identification of bubbles ; and the stages in th...

Looks like SNL is finally starting to put Obama in the cross-hairs: The funniest part (a little rude, but funny nonetheless) is about 2/3 of the way through - "Will you kiss me? I believe it is the polite thing to do when someone is doing sex to me!" Not a good sign for the President - to this point, comics have been slow to start ragging him. Looks like the honeymoon's over.

A friend just sent this. They call this guy (Robert Muraine) "Mr Fantastic" after the rubber-limbed comic-book hero in the Fantastic Four. Here's a clip of his entry on "So You Think You Can Dance". I used to have what's called hyper-mobile joints (before I got old and still) - I could easily get my elbows well past each other behind my back, do full splits, get my feet behind my head, and so on. But this is in a whole 'nother world.

In last week’s post I mentioned three stages in the evolution of a market: Identifying full-blown bubbles is easy. What’s not so easy is identifying the transitions that bookend a bubble. It’s not easy to know precisely when a rational, fundamentals-driven boom will morph into an irrational, sell-to-the-greater-fool frenzy. It’s not easy to know precisely when an irrational frenzy will reverse into an equally irrational stampede for the exits. These three stages – rational boom, frenzied bubble, irrational panic – are in fact just three out of a total of six stages in my own idiosyncratic (and highly unscientific) taxonomy of bull and bear markets. Here’s how it works. The first stage in any bull market is what I like to call the bounce . A sector or asset class that has been moribund for years or even decades suddenly starts rising in price. This could be due to exogenous shocks such as regulatory or technological changes; it could be due to Schumpeterian creative destruction , wh...

This sounds like a couple of my students. For some reason, family deaths always seem to increase around exam time.

In an opinion piece written for the Financial Times on Monday, former Fed governor (and current Columbia professor) Frederic Mishkin argues that central bankers cannot reliably identify asset-price bubbles; that certain types of bubbles – specifically, those without a credit element, which Mishkin calls ‘pure irrational exuberance bubbles’ (sic) – do not do much harm when they pop; that central bankers should not, in fact, try to pop the latter type of bubble; and that when in doubt a central banker should err on the side of benign inaction. Implicit in all these arguments is the Greenspanist view that policy is better suited to mitigating the painful after-effects of a popped bubble, than it is to spotting and deflating the bubble in the first place. I was under the impression that this particular stance had been discredited along with the rest of Alan Greenspan’s philosophy of central banking, but evidently not. Here are the relevant quotes from Mishkin’s piece: Because the secon...

Yesterday, I thought I was coming down with something - I had a sore throat when I went to bed, and I woke up this morning feeling kind of blah. So, I thought I'd muddle through my classes (unfortunately, it's my long teaching day), and then come home and go to bed. By the end of the day, I felt like I'd been beaten with a stick - sore and feeling heavy-limbed all over. But, it was the Unknown Daughter's birthday, so we had festivities first. Then, I thought I'd put in a little work on before going to bed. Big mistake. I started working on some spreadsheet models for my Fixed Income class at about 9 (just for an hour or so, I thought). Before I realized it, it's 3 a.m., and I've stayed up too late once again. So far, I've made two spreadsheet models. One calculates duration and convexity for any combination of coupon, maturity, frequency, and yield, along with some graphs. The other calculates the average life of a mortgage pass-through based...

Human beings are good at interpolation, passable at extrapolation, bad at identifying inflexion points, and downright terrible at processing one-off events. It’s no coincidence that these skills are, sequentially, associated with increasing investment success: the harder it is to do something, the more money one makes for doing it. This particular progression from easy to difficult is not merely the artifact of some deep-seated behavioral tendency or evolutionary bias. Deterministic and presumably unbiased algorithms, faced with unprecedented events, perform just as badly as humans. This is only to be expected: the very word ‘unprecedented’ implies that there is no baseline to build from or compare with, a circumstance under which most algorithmic approaches tend to flounder. Unfortunately for all concerned, real life is full of one-off events. What we call history is, as Rudge memorably puts it, just one bloody thing after another . And that’s precisely why I’m suspicious of atte...

Disclaimer: the following post is not for the faint of heart (or for those who have an overly developed sense of propriety). But then again, most of my readers aren't in those categories anyway. Since I recently turned 50, I got to have that little procedure that comes with the turf - a colonoscopy. The actual deed wasn't bad at all, but the prelude was, shall we say, less than enjoyable. Since the docs want a clear "field of play". they make you go on a clear-liquid diet for the day prior to the procedure. So, I got to teach 3 classes on a diet of Jello, black coffee, and chicken bullion - not the easiest thing to do. More importantly, they give you what they call "prep". the best way to give you a feel for what that involves is to point you towards this this classic video (warning: may not be safe for work - so turn the audio down a bit). The "prep" is essentially laxative mixed with rocket fuel. On the bright side, I got to read a coup...