Monday, September 20, 2010

Golden Opportunities and the Psychological Stages of a Bubble

One of the questions I get all the time is: are you a Gold Bug?

The question falls to both the negative and positive perceptions of the term 'gold bug'.

The short answer is that I'm not. Philosophically I am not one of those who believes that a return to the Gold standard is imminent or desireable.

I am firmly of the belief that Gold is not money... nor is it a hedge against inflation (it performs that role very poorly).

What Gold is, however, is a hedge against the mismanagement of the state - which at this time and place is the United States with it's world's reserve currency status. And since it is almost a certainty that the United States will be forced to continue Quantative Easing, it seems clear to me that the world is going to turn to the medium of Gold on a level they haven't for almost 100 years.

Thus, as clearly as I can see the warning signs for moving out of real estate as an investment, I can also see the warning signs that Gold/Silver represent an opportunity.

The Western World has squandered the past ten years pretending that magical thinking and trillions yuan/dollars/euros/yen in new debt and consumption would create a prosperity as profligate and enduring as the fifty years between 1950 and 2000.

2001 -2010 has been a decade of "extend and pretend," and the collapse of the financial New World Order in 2008 only triggered a paroxym of more of the same: more debt, more obscuring, more obstruction, more propaganda, more facsimiles of 'reform', all launched in the name of more credit-based consumption, as if credit-based consumption was the cure instead of the disease.

As in the 1930s, the world is embarking on massive debt deleveraging process. And just like in the 1930s, governments are trying to prevent the inevitable.

And as with the the 1930s, the country that holds the world's reserve currency is in a massive debt position from which they are facing a monumental challenge which will dislodge them from their position as the reigning power in the world.

The world is becoming aware of that fact. Last week Central Banks outside of the United States cut holdings of U.S. Agency Debt by 7%.

It's only the latest example of a worldwide paradigm shift which is going to see a stunning shift into Gold/Silver as a hedge against American mismanagement.

I'm not a Gold bug... I'm a Gold/Silver opportunist. And there is a huge opportunity ahead, IMHO.

Psychological Stages of a Bubble (and our Real Estate Bubble)

(Click on image to enlarge)

This will be long and I am posting it for some colleagues of mine who have recently started to read this blog.

I came across this outline of the psychological stages of any bubble on the Irvine Housing Blog. It provides an excellent insight into understanding what is going on in the Vancouver Real Estate Bubble.

Once a bubble starts to form, it will go through several identifiable stages: enthusiasm, greed, denial, fear, capitulation, and despair.

Each of these stages is characterized by different speculator emotional states and different resulting behaviors. There are outside forces that also act on the market in predictable ways in each one of these stages. Most often, these outside factors serve to reinforce the market’s herd behavior and exacerbate changes in price.

Precipitating Factor

There is often a precipitating factor causing the initial price rally that pushes prices above their supported fundamental values. A bubble rally is usually kicked off by some exogenous event, but it may occur simply because prices have been rising and investors take notice (Vancouver in 1987 - 2001 as the success of the rising dot com bubble offered fuel to bid up real estate), or it can be merely the result of a lack of investor fear and the widespread belief prices cannot go down. In a securities market, a precipitating factor may be a very large order hitting the trading floor, and in a real estate market it may be a dramatic lowering of interest rates as it has been in our Great Housing Bubble. Regardless of its cause, the initial price rise has the potential to spark sufficient interest to prompt further buying and set a series of events in motion which repeat with a remarkable consistency. Market bubbles can be found in all financial markets and on multiple timeframes.

After a property buying binge that had been fueled by the profits of the blowing of the dot com bubble in the 1990s, came the bursting of the bubble and the terrorist attacks of September 11th, 2001.

To combat what would have been a painful recession, interest rates were dropped and remained supressed for a 10 year span of artificially low rates. 10 years of steadly decling rates produced 10 stunning years of meteoric increasing prices; pushing Vancouver Real Estate into overdrive.

As you can see by this chart of Vancouver real estate prices (a chart which starts in 1977), the start of artificially suppressed interest rates in 2001 is identical to when the real estate bubble started to kick into overdrive. (click on the image to enlarge):

Enthusiasm Stage

At the beginning of the enthusiasm stage, prices are already inflated (as Vancouver prices were from the 1990s), so there is cautious buying from traders looking for trends and momentum. If prices fail to drop to fundamental valuations and instead push higher, media attention is often drawn to the speculative market. The general public starts to take notice of the money being made by people who have bought the featured asset and they begin to participate in larger numbers. Of course, this stimulates more buying and prices continue to climb. The market sentiment turns very bullish. Buyers are everywhere and sellers are scarce. At this point, prices are completely detached from fundamental valuations, but people are not buying because of the underlying value, they are buying because prices are going up.

After 2001 condo pre-sale mania followed this pattern exactly.

In residential real estate markets, the enthusiasm stage is often greeted by lenders with open arms. With prices rising, there is little risk of loss from default. If a borrower gets in trouble, they can simply sell into rising prices, and neither party takes a loss. With neither party fearing loss, and since lenders make most of their money on the transaction itself through origination fees, there is an inevitable lowering of standards to meet market demand. This in turn creates more market demand leading to further lowering of standards. The credit cycle reinforces the bullish psychology in the market and helps push prices even higher.

Greed Stage

In the greed stage, the bullish sentiment reaches a feverish pitch and prices rise very rapidly. Every owner in the market is making money and most believe it will go on forever. As prices continue to climb, buyers become very enthusiastic about owning the asset, and they tell all their friends about their great investment. The word-of-mouth awareness and increased media coverage bring even more buyers to the market. Egomania sets in as everyone thinks she is a financial genius. Any intellectual analysis at this stage is merely a cover for emotional buying and greed.

Everyone in Vancouver knows of instances of properties receiving a dozen or more offers the day they were listed, with many in excess of the asking price. Even in the past year, this has been the story of real estate.

Most people who are bullish already own the asset, but for prices to continue to rise there must be more buying. For buying to occur, someone who was either bearish or ignorant of the rally must be convinced to buy. In other words, a greater fool must be found. Once everyone is made aware of the market rally and is convinced to buy, you simply run out of new buyers. Once there is a shortage of potential buyers, prices can only go down.

Denial Stage

This is the stage where Vancouver, and Canada, currently sits.

When the limit of affordability is reached and the pool of available buyers is exhausted, prices start to decline. At first market participants are still overwhelmed by greed, and they choose to ignore the signs that the party might be over. In 2010 our real estate market sits in this stage as prices did not drop enough 1n 2009 to cause real fear. Denial is apparent as most people still believe their home would rise in value over the next five years, and believe a house is a good investment.

Right now we are in a period where the inventory is large, houses stay on the market for a long time, and prices are too high. Sellers who refuse to lower their prices to take a small loss are in denial about the state of the market. They believe bids will increase and some buyer will come along and pay their price after all, that is the way it was just a couple of years ago.

Those Buyers who bought in the enthusiasm stage are still ahead, so they feel no urgency to sell. They have made good money already and they will hold on with hopes of making a little more. Since they believe the asset will appreciate again (and they have no exit strategy), this group of buyers does not sell.

In the denial stage of a residential real estate market, many speculators are unable to obtain the sale price they desire. The accumulation of unrealistically priced houses starts to build a large inventory of homes “hanging” over the market. Overhead supply is a condition in a financial market when many units are held for sale at prices above current market prices. Generally there will be a minor rally after the first price decline as those who missed the big rally but still believe prices will only go up enter the market and cause a short-term increase in prices.

This is what happened in the first part of 2010. This is a bear rally.

It is aptly named as those bullish on the market buy right before the bear market reverses and quickly declines. For prices to resume a sustained rally, the overhead supply must be absorbed by the market. Once prices stopped going up and actually began to fall, demand is lessened by diminished buyer enthusiasm and the contraction of credit caused by mounting lender losses. With increasing supply and diminished demand prices cannot rally to absorb the overhead supply. The overall bullish bias to market psychology has not changed much at this point, because owners are in denial about the new reality of the bear market; however, the insufficient quantity of buyers and the beginnings of a credit crunch signal the rally is over and the bubble has popped.

Fear Stage

In the grieving process there is a shift from denial to fear when the reality being denied becomes too obvious to be ignored or pushed out of awareness.

We are now on course for 4 consecutive months of declining sales. In Victoria sales are off 75%. In the Okanagan, prices are being slashed 50%. Bob Rennie slashed prices of some new condos downtown by 40% earlier this month. The market is shifting and we are near the end of the denial stage in Vancouver. What follows now is a blueprint for what lies ahead in Vancouver.

As we shift to the Fear Stage, there is no acceptance of reality, just the idea that reality might be fact. The fact that an investment might turn out to be a very poor financial decision with long-term repercussions to the speculator’s financial life is generally very difficult to accept. The imaginings of a horrifying future creates fear, and this fear causes people to make decisions regarding their investments.

The most important change in the market in the fear stage is caused by the belief that the rally is over. Price rallies are a self-sustaining price-to-price feedback loop: prices go up because rising prices induces people to buy which in turn drives prices even higher. Once it is widely believed that the rally is over, it is over. Market participants who once only cared about rising prices suddenly become concerned about valuations. Since prices are far above fundamental values and prices are not rising, there is little incentive to buy. The rally is dead.

Another major psychological change occurs in this stage after people accept the rally is dead: people reassess and change their relationship to debt. During the rally, debt becomes a means to take a position in the housing commodity market. Nobody cares how much they are borrowing because they never intend to pay off the loan through payments from their wage income. Most believe they will pay off whatever they borrow in the future when they sell the house for more than they paid. Once prices stop going up, people realize they are simply renting from the bank, and the only way to get ahead and build equity is to pay off a mortgage. The desire to borrow 8 to 10 times income diminishes rapidly as people realize they could never pay off such a large sum. What started in the denial stage as an involuntary contraction of credit, in the fear stage becomes a voluntary contraction of credit as people simply do not want to borrow such large amounts of money.

By the time a financial market enters the fear stage, greed stage buyers are seriously underwater. Comparable properties may be selling for 10% less than their breakeven price, and there is little hope that prices will rally. Some sell at this point and take a loss, but most do not. People who bought in the enthusiasm stage come up to their breakeven price and face the same decision the greed stage buyers faced earlier: sell now or hold out for a rally. Even though there is good reason to fear, most do not sell here. They regret it later, but they hold on. Speculators generally only sell an asset when the pain of loss becomes acute. The pain threshold is different for each individual, but there is no real pain until the investment is worth less than the purchase price, so few sell for a profit or at breakeven. Inventories grow in the fear stage because many would like to sell, but sales volumes are light because few are willing to sell at prices buyers are willing to pay.

Prices do not rally here because there are even fewer buyers in the market and a reduced appetite for debt due to the change in market psychology. There are more and more sellers either choosing to sell or being forced to sell, and since there are more sellers than buyers, prices continue to drop. During the fear stage, a majority of buyers during the rally go underwater on their mortgages and endure the associated pain and stress. In the past, since the bubbles of the 80s and 90s were largely built on conventional mortgages, people just held on. During the Great Housing Bubble, people used exotic loan financing terms, and they simply could not afford to make their payments. They borrowed from other sources until their credit lines were exhausted and they imploded in foreclosure and bankruptcy. During this stage many renters who would otherwise have purchased a home put off their purchase and save more money because they correctly see the decline in prices has momentum and prices should continue to drop further.

Capitulation Stage

The transition from the fear stage to the capitulation stage is caused by the infectious belief that the rally is over. There is a tipping point where a critical mass of market participants either decide to sell or are forced to sell. In residential real estate, people are compelled to sell by anxiety, and the mechanism for force is foreclosure. Once a critical mass of selling is reached, the selling causes prices to decline further which in turn causes more selling. This convinces even more people the rally is over yielding even more selling: a downward spiral. The same price-to-price feedback mechanism that served to drive prices up during the rally works to drive prices down during the crash. Collectively, everyone in the market accepts prices are going to drop further, and they need to get out: Now!

Of course when everyone knows prices are going to drop, and everyone is trying to sell, there are very few buyers. Each market participant has a different threshold for pain. Some give up early; some give up later; some stubbornly try to hold on, but in the end, by choice or by force, everyone who cannot afford their home sells out and capitulates to the forces of the market. Each seller accepts the market rally was a bubble, and the frenzy of selling activity clears out the overhead supply. The capitulation stage is the counterpart of the greed stage. Sellers are everywhere and buyers are scarce. This puts prices into free-fall until a critical mass of buyers is ready to buy again.

Despair Stage

From a perspective of market psychology, it is difficult to tell when the capitulation stage ends and the despair stage begins. Both stages have an extremely negative bearish sentiment. It is called the despair stage because most who own the asset are in despair and wish they did not own it, and the general public is still selling. Most who still own their homes are able to afford the monthly payments, but realize they will face a large loss if they sell their house anytime soon. They feel like prisoners in their own homes because they are unable to relocate for a better job or any other reason. One distinguishing feature of the despair stage is the increased buying activity of investors–true investors, not the speculators who were wiped out during the price decline. Investors are not in despair during this stage. This is the time they were anticipating to make their purchases.

The unwinding of any bubble usually takes the same amount of time it took to build up.

I believe the Vancouver Bubble started to build in 1987 and took off in earnest in 2001. That's 23 years. I believe the Vancouver market will unwind over the next 20 years and values will fall to what they were in the mid 1980s.



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  1. Gold is the ultimate faith based commodity.
    Ironically, if the US ranks number one among all nations in gold holdings (8,133.5 tonnes in 2009 according to sources quoted on Wiki), shouldn't we be worrying less about the USD when the price of gold is going up, unless the US is lying about its gold holdings?
    Also, I am curious about how many mutually exclusive claims via derivatives exist relative to the total amount of underlying physical gold. Could gold be the next con game?

  2. ATP: The US may very well be lying about its gold holdings; there is no way to audit it. Also, there is no relationship between the US (fiat) dollar and their gold holdings.

    It's hard to imagine a R/E collapse back to mid 80s price levels but it could certainly happen. We have become so inured to unaffordable prices it seems inconceivable, but who would have thought we'd reach a million dollars for the average Vancouver house...?

  3. You're suggesting mid 80's prices adjusted for inflation right?

  4. Bob, at the very least.

    ATP, as you know there are far more paper claims to gold that there is gold - setting the stage for a massive panic if/when that plays out.

  5. @anonymous above:

    If there is no relationship between the US (fiat) dollar and their gold holdings, then arguments made by the 'sound' money camp for 'honest' currencies backed by gold must also be invalid. One can't argue both ways.