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The Seven Immutable Laws Of Bubbles:

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The Seven Immutable Laws of Bubbles: Example, Housing Markets in USA, UK & Dubai

Housing-Market / Liquidity Bubble

Jul 17, 2009 - 12:48 PM

By: Andrew_Butter

The cycle of bubble and bust in housing is drawing to a close. For many the ferocity of the bust and the collateral damage that followed was a shock, but bubbles and busts are not new; chances are there will be more.

I got interested in bubbles in early 2008 trying to figure out why my model of real estate prices that had worked perfectly for ten years was saying that prices in Dubai which is where I was at the time, "should" have been 30% less than where they were.

http://www.marketoracle.co.uk/Article12114.html

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Hmm, interesting article, but rather hard to follow in places. Not a well organised piece.

I am surprised that Butter reckons UK housing might be 20-30% undervalued now if the "long wave" pricing model works. He graphs UK housing as undervalued now, though not by this amount.

He talks about "smart" market value and graphs over and undervaluations but doesn't explain how he estimates these values.

He also thinks house prices should be an "exact" function of GDP per house and interest rates, yet this doesn't seem to take into account the fact that bubbles themselves (and the debt taken on in them) increase nominal GDP.

Overall, I am not convinced this guy knows what he is talking about.

The recent up-tick in UK confuses me, either it's an illusion (http://www.marketoracle.co.uk/Article10895.html), or the UK inflation is a lot more than is being reported; that wouldn't be the first time. Given the decline in the value of the pound over the past year, it's quite possible inflation was imported. And of course inflation is the saviour of the imprudent; and if you can have inflation by stealth, so much the better.

But either way, unless the economies collapse completely (I'm not qualified to judge that but my gut-feeling is that's unlikely and the bounce in stock markets (which are in line with market-long-wave dynamics (http://www.marketoracle.co.uk/Article10604.html)), suggests that some companies are figuring a way out of the hole. Assuming say 2% nominal GDP from here on that could translate into 9% to 11% increase in prices per year from whenever the bottom is reached, which I reckon will be latest within a year. So right now, it's likely that pockets will start to emerge where it makes sense to buy.

In that context the 125% LTV that is being talked about in USA and that Nationwide (a UK mortgage provider) is offering to existing customers in UK is not crazy; in fact it is smart. The point is that a foreclosed house will always fetch less than one that is sold "after proper marketing", and if a 125% mortgage can keep someone in his home until the mispricing down dissipates, that can work. But you have to wait until you are pretty close to the bottom before doing that.

In other words leveraged gambles are "smart" if you know that the market is going up. Well duh.

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Seeking Alpha Andrew Butter » Profile

Born in Kenya educated at Charterhouse, Leeds Art College and Cambridge University (MA Natural Science).

•1978-1988: Engineer and project manager in UAE and Saudi Arabia

•1989-1995: Ran a market research company in Dubai

•1995-1996: Arthur Andersen Bahrain, UAE and Jordan

•1997-2002: Investment advisory and valuations GCC, Lebanon and Iran

•2003-2007: Ran a real estate development management company in Dubai

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http://www.marketoracle.co.uk/Article12114.html

Law #1: All bubbles need a catalyst, like a stone to throw into a still pond.

Bubbles start in "good times", typically GDP is going up and people have money to spend and invest, so money starts chasing assets and if it takes time for the supply of those assets to increase, prices go up.

For example, the fundamental price of housing long-term is exactly equal to nominal GDP per house divided by a function of long-term interest rates (http://www.marketoracle.co.uk/Article6250.html). When nominal GDP goes up a lot faster than the supply of housing does, then the price of housing goes up; that's supply and demand, there is nothing wrong with that but it's the pebble in your hand; just you didn't throw it yet.

Law #2: Easy Money

Years ago I was friends with old man from Texas, he had a big silver buckle on his belt and crocodile-skin boots, and he used to eat three fried eggs, a slice of steak, for breakfast, extraordinary! Lovely guy; full of stories, he had a sidekick called Ron, and Ron wore "Blues Brothers" shades, and never said a word. I was just a kid and he was like in that Jerry Jeff Walker song..."Desperado Waiting For A Train" which he used to play on his car cassette-player over and over; it was that long ago. Anyway he'd been through the S&L and well, let's say, he was a long way from home.

One day I asked him "what happened"? He said "Son"...when he was being serious he always used to say that..."Son when the money starts chasing the projects not the projects chasing the money, that's the time".

If credit is available at less than the asset price inflation, people who participate can make money from nothing, and the reason they buy becomes less about getting something they want and more about playing that window.

That draws more money to compete for the already limited supply of assets, that's the start of the bubble, like the stone thrown into a pond.

Law #3: Greed starts bubbles, fear drives them.

In every bubble the "Early-adopters" make fortunes, but they are the minority; the real drivers of every bubble are those who came late, that's the way pyramid schemes work; for every winner, there has to be a sucker. Greed of course plays a role, in the beginning the maxim is "those who snooze loose"; then comes fear.

In the recent housing bubbles in USA and UK, ordinary people watched in horror as the price of a home spiralled out of their reach. The option was join the circus, or downgrade; in America what that often means is moving to a neighbourhood with lousy schools and violence.

America more than perhaps any country in the world is a carrot and stick society. Much is said about the "carrot", but the stick is just as big an incentive; lose you "medical" and you join the "deadbeat" class.

Wherever you look it up, the standard definition of a valuation says something about market participants acting "knowledgeably, prudently and without compulsion"; greed affect that equation a bit; fear affects it a lot.

Law #4: Knowing the price of everything and the value of nothing.

Ask anyone from Generation "X" what's the value of something and he will tell you "that's the price I can get someone dumber than me to pay". There is another way to value things (or services), and that's the price someone smarter than you will pay.

When those two prices are not the same the market is in what International Valuation Standards (http://www.ivsc.org/) calls, disequilibrium. George Soros has another word for that he, calls it market mispricing.

Dumb valuations are an essential component of any bubble, first because they convince the suckers to pay, and second because they convince banks (and all the rest), to keep on supplying the credit, which is the essential lubricant of such perpetual motion machines, and when the bankers start lending money without understanding value, that drives the bubble forward.

Lending money against collateral is of course not a new idea; the trick, which gets forgotten from time to time, is that it's a good idea to make sure that what you can sell your "pound of flesh" for, will be more than the loan you wrote. "Will" is the operative word there, knowing what you might have sold it for yesterday (i.e. mark-to-market) doesn't help; the price you can reasonably expect to sell it for anytime in the future is called the "smart" price.

That's what IVS calls the "other than market value", which they mandate you should report when the market is in disequilibrium.

A big part of the problem was that neither banking regulators, nor the Basel II guidelines, nor the accounting profession recognise IVS (notwithstanding that it is accepted by every valuation institute in the world of any consequence).

That's what Chairman Bernanke calls "pro-cyclical" although he appears to only understand how that affects valuations after a bubble. Building up to a bubble the more money that is lent, the higher prices go, which means that even more money can be lent.

Combine that with the convention that the moment in time you lost money after you wrote a loan to someone who had no intention of paying it back, was not the moment you handed the money over, it's the moment that you realise (a) you aren't getting your money back and (B) that the price you can sell the pound of flesh for, is less than the money you advanced; and the mix can get explosive.

The operative word there is "realise", and if you don't realise, well you can still call it an asset; that's the reason bankers, accountants, banking regulators, and rating agencies are so determined to know nothing about valuation, because if they did, then they would have no excuse. So the result is that it’s "safer" to proceed boldly forwards in blissful ignorance, and the ultimate driver of a bubble, is ignorance.

Law #5: The fatal seduction of New Paradigms.

Remember the Dot.com boom? They had these complex formulas for how you could value a company that had never made even an approximation of a profit, let alone had a coherent business plan.

Of course that was a "New Paradigm" with some magical new powers, like the Tulips in Holland all those years ago, and that's why the "Old Rules" did not apply anymore, at least that's what everyone thought.

Ultimately it's all about valuation, and if something is new, it's harder to do a valuation.

Dumb valuation is easy, you just follow the herd, but doing a smart valuation is harder, you are supposed to get hold of "sufficient" historical market-derived data, and show that in the past this data could be used reliably to arrive at the price from independent market drivers. What that means is that you can't just do a plot of price against time and assume that because in the recent past price correlated with time, that's how it will be in the future, time is not a valid market driver.

When the geeks start plotting daily prices for three years and declaring that "Eureka" price correlates with time with a 95% R-Squared, you got a problem.

Law #6: Judging the "Pop".

When I was a kid I used to go surfing, you learned the hard way to figure when a wave was going to break (hard like being bounced along the coral), a wave of a certain height breaks in a certain depth of water, so the big ones break out further than the small ones, and they come in sets of seven. And when it hits its depth, then bang!

Judging the pop is the hardest part, typically the wave builds up to a peak then inside it starts rolling over, but you don't see that; it's like the last gasp, but when the rate of increase starts to drop, that's the time.

Law #7: The amount of wealth created by a bubble is always less than zero.

Bubbles create no long-term economic value. Often they encourage people to borrow to spend money on luxuries, rather than investing in capability that might in the future create value that could be used to pay back a loan, for example an education, a technology, a franchise...etc. That "waste" is how bubbles often end up destroying economic value.

The reality is that it's impossible to create wealth from nothing, that's just re-stating the Second Law of Thermodynamics.

Of course some people make money, but that's just a redistribution of wealth, and in that regard, the recent Bubble and Pop in housing probably represents one of the greatest re-distributions of wealth in the history of mankind (mainly from poor people who got into the pyramid late only when lending standards dropped, to rich people who got in (and out) early and had the advantage of good credit scores).

The interesting thing about that is the amplitude x the period of the mispricing on the high side, is typically exactly reflected in (the amplitude x the period) of mispricing on the low side.

What that says in effect is that a bubble and bust is a zero-sum game, and in the end no wealth is created, which is another way of re-stating the "efficient market hypothesis"; i.e. that mispricing up must be balanced by mispricing down.

One way of looking at that is the pebble thrown in the pond, the amplitude and periodicity of "up waves" is typically exactly mirrored in the amplitude and periodicity of the "down" wave, the net result is zero sum.

bubbles-17-1.gif

bubbles-17-2.gif

etc...

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