Does Ben Bernanke blow bubbles too?
During Alan Greenspan’s tenure at the helm of the Federal Reserve, he was often accused of using monetary policy to target asset markets so as to keep the party going. In short, Alan Greenspan was seen by many, including myself, as the bubble blower-in-chief. All of this came to an end with the very hard landing we have experienced after the global housing bubble.
However, despite the economy being in tatters and debt deflation looming as a threat, many asset markets have zoomed ahead. The cause: easy money in the U.S. and elsewhere. In the U.S., we have zero percent rates with Ben Bernanke at the helm. So, naturally, you should ask yourself: Does Ben Bernanke blow bubbles too?
To get at an answer to that question, I want to highlight a recent post on MoneyWeek called “The next big investment bubble – green energy.” In this article, research from James Montier of SocGen about investor attitudes in bubbles is quite enlightening.
James Montier at Societe Generale is a specialist in ‘behavioural finance’. This basically takes psychology and applies it to the field of investment and economics.
As someone who’s studied psychology in the past, I’d be the first to admit that it’s a pretty ‘soft’ science compared to something like physics, for example. But compared to the pseudo-science that is economics, it’s positively respectable.
And given that markets are anything but rational (even the Chartered Financial Analyst Society of the UK admits that a majority of its members have lost faith in the ‘efficient markets hypothesis’), it makes a lot of sense to take investors’ all-too-human characteristics into account when trying to figure out what markets might do next.
In a recent research note, Montier took a look at the psychology of bubbles. As suggested earlier, you’d think that investors would learn. If they’d seen one bubble, they’d be more careful in future.
And in fact, they do learn. An experiment conducted by joint Nobel prize winner Vernon Smith used an investment game where investors could trade a dividend-paying equity under four different random economic conditions, each of which would result in a different dividend payout.
In the first game, investors at first undervalue the equity, then massively overvalue it, creating a bubble which then deflates. Smith then got the same people back to play the game again. What happened? Well, says Montier, “far from learning from their experience in the first round, participants generally go on to create yet another bubble!” And when they were asked why, “the most common response was they thought they could get out before the top this time!”
However, when Smith asked the same players to play a third time, this time they’d learned. “You end up with a much tighter correlation between the market price and fundamental value,” says Montier.
So twice bitten, thrice shy, it seems. And you might therefore expect the current generation of investors to have learned from the two big bubbles of the past decade.
…but they can get sucked into creating them
But that’s not the end of the story. Smith found that there was a way to get experienced investors back into bubble mentality. How? He cut the amount of stock available in half, and doubled the amount of cash in the game, “effectively creating what might be termed a massive liquidity surge.” This time around, even the experienced investors were sucked back into creating another bubble, although it peaked earlier than the previous ones.
“A massive liquidity surge” is exactly what the world’s central banks are trying to create just now. Montier says he has no idea if it will be large enough to “reignite a bubble (and of course another crash afterwards).” But as US fund manager Jeremy Grantham of GMO has pointed out previously, we’re currently seeing “the greatest monetary and fiscal stimulus by far in US history”. So if that doesn’t do it, arguably nothing will.
What does that tell you? It tells me that while many are chastened, the recent surge of liquidity is likely to result in bubbles nevertheless. The article looks to ‘green energy’ as a likely bubble market. But in “The next bubble” FT Alphaville look to a more conspicuous place, emerging markets. This article is definitely worth reading.
I would also point to the recent 40% surge in U.S. equity prices as evidence that liquidity factors are at play and that a bubble mentality is returning. Moreover, $70 oil in a period of depressed demand for oil doesn’t speak to a market running only on fundamentals. If oil prices are $70 today, they most certainly can and will rise to $100, $150 and beyond if recovery takes hold and demand returns.
Therefore, in my view, Ben Bernanke does blow bubbles too.
Below is the research note from Montier which inspired this post.