Drivers of Financial Bubbles: Addicts and Enablers

I recently ran across an interesting article by stock analyst Gary J. Gordon, The Bubble Addicts Are Here To Stay: A Bubble Investment Strategy. This article may be behind a paywall.  I will summarize it here. Direct citations are in italics.

SOME RECENT FINANCIAL BUBBLES

Gordon starts by recapping four recent financial bubbles:

The commercial real estate bubble of the mid-1980s

The internet stock craze of the late 1990s (with the highest price/earnings valuations ever – – e.g., a startup called Netbank possessed nothing but a website, yet was valued at ten times book value; and went bankrupt a few years later)

The mid-00s housing bubble.

The 2020/2021 COVID bubble:  “The trifecta of a ‘disruptive business model’ stock bubble, SPACs and crypto. You know how this story is ending.”

Gordon then presents an explanation of why humans keep doing financial bubbles, despite the experiences of the past. He suggests that there are both bubble addicts, who have a need to chase bubbles and therefore create them, and bubble enablers who are only too happy to make money off the addicts.

THE BUBBLE ADDICTS

The greedy. Some of us just think we deserve more. I think of an acquaintance who said he was approached to invest with Bernie Madoff, who famously promised steady 10% returns. My friend turned down the offer because he required 15% returns.

Pension funds. This $30 trillion pool of investment dollars targets about a 7% return in order to meet future pension obligations. If pension fund managers can’t consistently earn at least 7%, they have to go to their sponsor – a state government, a corporate CEO, etc. – and ask for more money, or for pension benefits to be cut. And probably lose their job in the process.

Back in the day, bonds were the mainstay pension fund investment. But over the past 20 years, bond yields haven’t gotten the pensions anywhere close to 7%. So increasingly they have invested in stocks and alternative investments like private equity, as this chart shows:

Source: Pew Institute

And venture capital fundraising, in large part from pension funds, has soared since the pandemic…

How many great new ideas are out there for venture capitalists to invest in? [Obviously, not an unlimited number]. So their investments are by necessity getting riskier. But if the pension funds back away from the growing risk, they have to admit they can’t earn that 7%. Then bad things happen, to retirees and to pension plan sponsors and then to pension fund managers. So pension fund managers are pretty much addicted to chasing bubbles.

The relatively poor. The “absolutely poor” have income below defined poverty levels. The “relatively poor” feel that they should be doing better, because their friends are, or their parents did, or because the Kardashians are, or whatever. Their current income and prospects just aren’t getting them to the lifestyle they aspire to. [Gordon provides example of folks chasing meme stocks and crypto, and getting burned]. …But can the relatively poor just walk away from chasing bubbles? Not without giving up dreams of better lifestyles.

THE BUBBLE FEEDERS

Bubbles don’t just spontaneously occur; they require skilled hands to shape them. And those skilled hands profit handsomely from their creations. Who are these feeders?

Private equity and venture fund managers. They typically earn a 2% management fee plus 20% of profits earned. That adds up fast. A $10 billion venture fund could easily generate $400 million a year in income, spread among a pretty small group of people. VC News lists 14 venture capitalists who are billionaires.

SPAC sponsors. [ A SPAC (Special Purpose Acquisition Company) is a shell corporations which raises money through stock offerings, for the purpose of going out and buying some existing company. SPAC sponsors make a bundle, and so are motivated to promote them. SPACs proliferated in 2020-2021, and for a while pumped money into acquiring various small-medium “growth” companies. But now it is clear that there are not a lot of great underpriced companies out there for SPACs to buy, so SPACs are fizzling]

Wall Street earns fees from (A) raising funds for private equity, venture capital and SPACs, (B) buying and selling companies, (C) trading bubble stocks, crypto, etc., and (D) other stuff I’m not thinking of right now.

The Federal Reserve. Part of the Federal Reserve’s mandate is to reduce unemployment. Lowering interest rates increases stock values, which creates wealth, which drives the “wealth effect”. The wealth effect is the estimate that households increase their spending by about 3% as their wealth increases. More spending increases GDP, which reduces unemployment, which makes the Fed happy, and politicians happy with the Fed.

In my view, the wealth effect is why the supposed economic geniuses at the Fed never figure out that bubbles are occurring, so they never take steps to minimize them.

Social media and CNBC certainly benefit from more viewers while bubbles are blowing up [i.e., inflating].

INVESTING IN CURRENT MARKET ENVIRONMENT

Gordon sees us still in recovery from the recent bubble of “disruptor companies” and crypto, and so the market may have more than the usual choppiness in the next year. So he advises being nimble to trade in and out, and not mindlessly commit to being either long or short. “Value stocks are probably the best near-term bet, even if they can’t offer the adrenaline jolt offered by bubble stocks.”

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