The Politics of a Bubble

I am sure you have all heard of the housing "bubble" which is now collapsing.  You are probably also aware that there was a huge runup in the housing market from 2000-2007, and that this runup was  preceded by another collapsing bubble.

If you are into stocks, you are probably aware that AAPL used to trade at nearly $200, but is now at around $120 (and that AAPL used to trade at $50 not too long back).  You are probably aware of similar bubbles that have formed and collapsed in many other stocks.

Decisions having to do with buying and selling are made by rational people (one hopes, at least).  So why would any rational individual  have bought a house in June 2007, when all signs were pointing to an imminent collapse.  Why would anyone have bought CISCO stock in March 2000 at $ 78 (as I did), just prior to the imminent collapse which was quite expected.

And does that hold any lessons in politics ?  

The answer is quite simple really: humans are like penguins, and yes, it holds a lesson in politics.

A flock of penguins on the Antartic ice will push and shove until someone falls into the water.  Noone wants to jump in because they are all afraid of predators lurking in the water.  But the moment someone falls, and survives (meaning no predators around), they will all jump in.  Bubbles form sort of like that.

AAPL was being offered at $50 not too long back.  Noone wanted to buy at that level because everyone feared it's momentum would drag it further down.  But because it was undervalued, noone wanted to sell either.  And so, AAPL volume went down.  And then, some brave souls decided they would buy some AAPL stock...so the price went up by a little bit.  At this point, others looked at it and said...well, the price has gone up and not come down, so it must be a good stock.  So others jumped in and bought some more..thereby pushing the stock up some more...and some more...and some more...until it hit $200 (at which point it was clearly overvalued).

The housing market is sort of like that too, except it moves very  slowly compared to stocks (for obvious reasons).  Prof. Shiller (of the Case-Shiller housing index fame) has an interesting article in the NY Times on the latest housing bubble

http://www.nytimes.com/2008/03/02/busine ss/02view.html?_r=1&oref=slogin

He quotes the work done by

"Three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, in a classic 1992 article, defined what they call "information cascades" that can lead people into serious error. They found that these cascades can affect even perfectly rational people and cause bubblelike phenomena. Why? Ultimately, people sometimes need to rely on the judgment of others, and therein lies the problem. The theory provides a framework for understanding the real estate turbulence we are now observing.

Mr. Bikhchandani and his co-authors present this example: Suppose that a group of individuals must make an important decision, based on useful but incomplete information. Each one of them has received some information relevant to the decision, but the information is incomplete and "noisy" and does not always point to the right conclusion.

Let's update the example to apply it to the recent bubble: The individuals in the group must each decide whether real estate is a terrific investment and whether to buy some property. Suppose that there is a 60 percent probability that any one person's information will lead to the right decision.

In other words, that person's information is useful but not definitive -- and not clear enough to make a firm judgment about something as momentous as a market bubble. Perhaps that is how Mr. Greenspan assessed the probability that he could make an accurate judgment about the stock market bubble.

The theory helps explain why he -- or anyone trying to verify the existence of a market bubble -- may have squelched his own judgment.

The fundamental problem is that the information obtained by any individual -- even one as well-placed as the chairman of the Federal Reserve -- is bound to be incomplete. If people could somehow hold a national town meeting and share their independent information, they would have the opportunity to see the full weight of the evidence. Any individual errors would be averaged out, and the participants would collectively reach the correct decision.

Of course, such a national town meeting is impossible. Each person makes decisions individually, sequentially, and reveals his decisions through actions -- in this case, by entering the housing market and bidding up home prices.

Suppose houses are really of low investment value, but the first person to make a decision reaches the wrong conclusion (which happens, as we have assumed, 40 percent of the time). The first person, A, pays a high price for a home, thus signaling to others that houses are a good investment.

The second person, B, has no problem if his own data seem to confirm the information provided by A's willingness to pay a high price. But B faces a quandary if his own information seems to contradict A's judgment. In that case, B would conclude that he has no worthwhile information, and so he must make an arbitrary decision -- say, by flipping a coin to decide whether to buy a house.

The result is that even if houses are of low investment value, we may now have two people who make purchasing decisions that reveal their conclusion that houses are a good investment.

As others make purchases at rising prices, more and more people will conclude that these buyers' information about the market outweighs their own.

Mr. Bikhchandani and his co-authors worked out this rational herding story carefully, and their results show that the probability of the cascade leading to an incorrect assumption is 37 percent. In other words, more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.

Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.

This theory poses a major challenge to the "efficient markets" view of the world, which assumes that investors are like independent-minded voters, relying only on their own information to make decisions. The efficient-markets view holds that the market is wiser than any individual: in aggregate, the market will come to the correct decision. But the theory is flawed because it does not recognize that people must rely on the judgments of others."

They go on to explain what happens to emotional individuals who do not act on rational facts.  The chances of running up a bubble is much higher in that case.

And that brings me to Obama.

I do not know if Obama has formed a "bubble" that is collapsing (i.e., the confidence placed on his abilities is overvalued, and that confidence is now dissipating), or if he is truly a great leader who is being properly evaluated by the markets (we can only know that in hindsight).  But, he was clearly languishing down low in the polls, and has managed to become very competitive (at the very least).  How does that happen ?

The runup in his support is similar to the runup in AAPL.  Person A listens to Obama and says "I like him, I will vote for him".  Person B listens to Obama, and says "I like him, but there is only a 60% chance that I will vote for him".  But Person B then hears Person A say that Person A has also heard Obama speak, and WILL vote for Obama.  This influences Person B to support Obama, inspite of his misgivings (i.e., the 40% chance that he would not have voted for Obama).  And so on to Person C etc.

Human beings being emotional (and not totally rational) creatures, this runup can take extreme forms (for instance, George Bush had a >90% rating after 9/11.  On hindsight, this clearly overvalued his worth as a leader).  The more emotional we are, the more likely we are to runup a bubble (and this would explain why the Obama campaign is so high on it's "yes, we can", "change we can believe in" etc. rhetoric.  He is definitely not stupid).

Just like AAPL stock, this runup will at some point result in an overvaluation (or a bubble) of the true worth of the "commodity" (in this case, an overvaluation of Obama's worth as a leader).  At that point, Person A will say "I do not like Obama, and I will NOT vote for him".  This will influence Person B, who may still have a 50% inclination towards Obama, and so on.  The Obama bubble will collapse (just like the Bush bubble of >90% approval collapsed steadiliy since the days after 9/11).  Has that point been reached ?  I do not know...we can only know that on hindsight (or if his valuation reaches extreme levels).  But it will be reached at some point.  The questions is whether he can win the nomination (and the Presidency) before his bubble collapse.

Why does the same rationale not apply to Clinton and John McCain ?  It does, but to a smaller extent.  They have already been through the bubble formation/collapse process many times, so their  worth is less likely to be runup to the same extent as is Obama's.  This can change if they manage to redefine themselves radically (as AAPL did, for instance, when they introduced the IPod, and word of the imminent IPhone leaked into the market).  Redefining yourself is not easy...not everyone is a Steve Jobs, Thus, McCain and Clinton are who they are, while Obama can be runup into a bubble.

Unfortunately, this analysis does not help me make any predictions on who will win, and who will lose.  It also does not enable any predictions on who will make a better President.      

It just makes me more interested in the political process.

Tags: AAPL, bubbles, clinton, housing, obama (all tags)

Comments

3 Comments

And for those who are considering buying a house..

Please read the whole NYTimes article

by SevenStrings 2008-03-05 02:30PM | 0 recs
Re: The Politics of a Bubble

I really enjoyed your diary; I'm not sure I have anything constructive (or contrarian) to say about it, though I suppose I would say that I think that the bubble impact in a presidential choice would be considerably less, since we only have one person one vote "purchase price" - rather than the  changeable valuation of real estate or stock.  Does that make sense?  No matter how many people decided to vote, their individual votes cannot be inflated in the same way real estate prices can be inflated.  Does that make sense?

by mgee 2008-03-05 03:52PM | 0 recs
Re: The Politics of a Bubble

Yes it does, and thank you for the complement!!

by SevenStrings 2008-03-05 04:30PM | 0 recs

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