Felix Salmon

Don’t fear the bubble

Felix Salmon
May 22, 2013 16:41 UTC

Tyler Cowen has no truck with the Bubble Crew. He aligns himself with Paul Krugman and against Jesse Eisinger; we can add Gillian Tett to Eisinger’s side of the debate, and Jim Surowiecki to Cowen’s.

The bubblista side of the argument, at heart, says that the flood of money being poured into the global economy by the world’s central banks is driving up asset prices to well beyond fundamental valuations, and that if and when valuations revert to sanity, the unwind (the “burst”) could be disastrous in all manner of unpredictable ways.

This is a prediction which is very easy to make, not least because it has no time stamp associated with it. Tett, indeed, says that “these distorted conditions will remain in place far longer than most people expect”, which is little a bit weird: the whole reason why assets are expensive is precisely because, as Krugman says, “long-term rates are low because people, rightly, expect short-term rates to stay low for a long time.” And when long-term rates are low, that doesn’t just affect the price of long-dated bonds; it also drives up the price of stocks, which have infinite maturity.

Still, this is a good place to start, because there does seem to be consensus here: low interest rates, across the curve, are causing asset prices to rise, around the world. Is that prima facie evidence of a bubble? I’d say clearly not. The first job of financial markets is to be a place where you can convert future cashflows into a present-day lump sum, and that lump sum is naturally going to be higher when interest rates are low. Similarly, if and when interest rates start to rise, asset prices may well start to fall. But that’s just what financial markets do: they go up, and they go down. Not every rise is a bubble, and not ever fall is a bubble bursting.

The word “bubble”, at least for me, is a loaded term, with a specific meaning. For one thing, it implies speculation: people buying an asset which is going up in price, just because they think they’re going to be able to sell it to a greater fool at a substantial profit. The dot-com bubble was a prime example of that, with investors jumping onto high-flying technology stocks not because they thought the stocks were cheap but just because they thought the stocks were rising, and that they could make money day-trading these things. Much of the housing bubble looked like that too: you could buy a tract home in Phoenix with no money down, hold on to it for a few months, and then flip it for a substantial payday — even if you never expected to live in it. And certainly the bitcoin bubble fits the bill: pretty much the only reason to buy bitcoins and hold them for more than about 10 minutes is that you think they’re going to go up in value and that you’ll be able to make money as a result.

Is it possible to have a non-speculative bubble? In certain rare cases, perhaps. For instance, there was the market in Impressionist paintings in the 1980s: they went up in value enormously, and then the bubble burst and values came back down again. But people weren’t buying these things to flip them, and — importantly — no real harm was done to anybody when prices stopped going up and started going down. Similarly, in 2007, I said that if Manhattan property prices were in a bubble, then it wasn’t a speculative bubble. And again, whether you call it a bubble or not doesn’t really matter: when Manhattan property prices declined during the housing bust, no real harm was done to anybody.

In any case, the truly defining characteristic of a bubble is surely its bursting. The reason to be worried about bubbles has nothing to do with fear of what happens when everybody is happily making money. Rather, the problem with bubbles is that they burst; bursting bubbles are dangerous, unpredictable things which we should rightly be afraid of. Or, to put it another way: if asset prices simply decline without causing substantial collateral damage, then you weren’t in a bubble to begin with; you were simply in a bull market which then became a bear market.

Looking at the markets today, they show every indication of being bull markets rather than bubbles. For one thing, there’s not much speculation going on: no one’s day-trading junk bonds. Eisinger says that the One Percent are getting wealthier “through speculation”, and cites private-equity firms in the “house flipping” business, but that’s really not what’s going on at all: the One Percent are getting wealthier just because they own stocks and those stocks are going up, while the private-equity firms buying houses aren’t flipping them, but are rather renting them out, as part of their global search for yield. That’s real investment, it’s not speculation. What’s more, when Eisinger points to this chart as evidence that stocks are overvalued, he’s pointing to a chart which shows that — except for a deep “V” at the very height of the financial crisis — shows stocks trading at pretty much their lowest valuation of the past 20 years. Nasdaq 5,000 this is not.

More importantly, investors aren’t leveraged in the way they were during the housing boom: no one’s buying houses with no money down, and no one’s borrowing billions of dollars to invest in super-senior CDO tranches. The dot-com bust wiped out hundreds of billions of dollars of paper wealth, but only caused a relatively mild recession: the reason was partly the fact that Alan Greenspan was able to slash interest rates, but it was also in large part a function of the fact that very little of the dot-com bubble was fueled by leverage.

Today’s markets might well be frothy — but, in the short term at least, that’s a good thing for the real economy. So far this year, we’e seen 1,413 companies issuing stock onto either the primary or secondary markets, raising $288 billion in the process — that’s up 33% from the same period last year. (And remember, the same period last year included the Facebook IPO.) Amazingly and wonderfully, that total includes $74 billion of issuance in Europe, up a whopping 44% from the same period in 2012. Companies don’t generally raise equity capital just to sit on the cash: they raise it so that they can invest the proceeds into their business, thereby creating jobs and economic growth.

Companies are raising equity capital right now because doing so is cheap for them: the higher that stock prices go, the more that we can expect this trend to continue. And that’s good for the economy. And, of course, investors are getting wealthier, which causes some nonzero wealth effect in terms of the amount of money they spend. So, what’s not to like, in terms of markets going up? If it means that the population gets richer and companies have more money to invest in their business, what’s the downside?

Over the long term, expensive stocks are bad for people who are trying to save for retirement: the more you pay for your investments, the lower your ultimate return is going to be. But that’s a relatively minor concern right now. The bubble-worriers have something else on their minds — something more moralistic. They see the rich getting a free lunch: central banks dropping money from helicopters, most of which is going directly into the pockets of the top 1%. That isn’t fair, and they are sure that there’s some kind of cosmic karma which means that wherever there’s a party, there’s bound to be a hangover.

The view that “we have to pay a price for past sins” is nearly always wrong, and in any event the only real sin being committed here is that the rich aren’t sharing their good fortune with everybody else. The stock market is a rising tide which is lifting only the luxury yachts; everybody else is underwater. That is genuinely deplorable. But it doesn’t mean that we’re in a bubble, and it doesn’t mean that if and when the tide goes out, the rest of us are going suffer massive injuries. There are always tail risks, of course: there are always unknown unknowns. But for the time being, the most likely scenario is that when asset prices start to fall, the main people to be hurt will be the ones owning the assets in question. In other words, the people who can best afford it. That’s not a bursting bubble: it’s just a common-or-garden bear market, of the type that all investors should be able to withstand.


Nice comment Ken_G!

Felix, surely it’s got more to do with behaviour and attitude to and perception of risk than it does to interest rates? People are currently falling over themselves to invest right now, and have been doing so in increasing numbers since September of last year. If you remember back to Mario Draghi’s comment about doing everythng necessary to protect the Euro, and that was when confidence returned to the market.

As share prices increased, consumers got more interested and started buying in increasing numbers. Share prices increased further. Despite the sceptics who for years have been berating the rest of us by forecasting nothing but doom and gloom, the Euro didn’t crash and burn, the US economy didn’t collapse under the weight of its rescue plan of QE stimulus, and even the Swiss Franc is now weakening against the USD, the GBP and the EUR as money moves away from safe havens and into areas of higher risk.

It doesn’t seem so long ago you were writing an article about the ever strengthening Swiss France before the Swiss National Bank protected it at a rate of Fr. 1.20 to the Euro; today it has weakened to Fr. 1.24 while yesterday it hit Fr. 1.27 for a time. The USD is now up from Fr. 0.92 to 0.96, and the GBP is up from a low point of Fr. 1.24 to a stronger Fr. 1.45 now.

Yes, there is profit taking, and I guess a lot of options are being cashed in too as they have suddenly become interesting again. As the executives pocket the proceeds of these freebies, they will begin to feel more expansionary in how they look at decisions and I am guessing will psychologically feel more inclined to take higher risks, dipping into their company cash piles and using the money for new projects to generate new profits and new growth.

Happy people invest more, spend more, and the economy benefits as a result. Anyhow, current stock market levels are only just thereabouts as high as they have been before, so how can that be a bubble? Yes, recent growth has been like that out of a recession, but I suspect it has a lot to do with suppressed demand and a wall of money hitting the markets needing a home to go to.

The optimists are returning and the pessimists have been shown up as scaremongers, often with selfish political not economic motivations for their words.

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The HP capital-structure arbitrage

Felix Salmon
Aug 1, 2012 15:49 UTC

Last week, Arik Hesseldahl — a tech writer who’s the first to admit he’s no expert on finance — discovered the wonderful world of credit default swaps in general, and single-name CDS on Hewlett-Packard, in particular. The cost of single-name protection on HP has been going up, and that can only mean one thing: it’s “mainly a barometer of the state of anxiety over its finances and its balance sheet”, he wrote.

Hesseldahl’s corporate cousins Rolfe Winkler and Matt Wirz followed up a couple of days ago:

A $10 million five-year insurance policy on H-P debt costs $260,000 according to data provider Markit. That price has doubled since April and quadrupled since a year ago. While there is no prospect of H-P going under any time soon, bond investors are clearly unhappy about the company’s deteriorating prospects and balance sheet.

But I don’t buy it. For one thing, as David Merkel points out in a comment on on Hesseldahl’s latest post, the HP bond market is not panicking at all: its bond prices remain perfectly healthy. He continues:

The markets for single name CDS are thin because there are no natural counterparties that want to nakedly go long credit risk. Those wanting to nakedly short credit risk therefore have to pay a premium to do so, usually higher than the credit spread inherent on a corporate bond of the same maturity.

And if one or two hedge funds want to do it “in size,” guess what? The CDS market will back off considerably, and make them pay through the nose.

It’s hard to spook the bond market for a liquid bond issuer; it is easy to spook the CDS market.

Why might one or two hedge funds suddenly want to buy protection on HP (and Dell, and Lexmark)? There’s an easy and obvious explanation: their share prices. HP, Dell, and Lexmark are all trading at less than 7 times earnings, at the lowest prices they’ve seen in a decade. They’re all in the fast-changing and volatile technology business. The only certainty here is uncertainty: it’s reasonable to assume that in five years’ time, each of these companies is going to be in a very different place to where it is now.

Which sets up an easy and obvious capital-structure arbitrage. You go long the stock, and then you hedge with single-name credit protection — the only way you can effectively go short the debt. The stock market is deep and liquid enough that you can buy your shares without moving the market; the single-name CDS market isn’t, but no mind. Even if you overpay a bit for the CDS, the trade still looks attractive, on a five-year time horizon.

In five years’ time, it’s entirely possible that at least one of these companies will be toast — in which case anybody who bought the CDS today will have scored a home run. On the other hand, if they’re not toast, the stocks are likely to be significantly higher than they are right now. Basically, the stock price is incorporating a significant probability of collapse, and if you take that probability away, then it should be much higher. And buying protection in the CDS market is one way of effectively taking that probability away.

This kind of trade only works for companies in unpredictable sectors that have low stock prices and relatively low borrowing costs; such opportunities don’t come along very often. But when they do come along, it’s entirely predictable that a hedge fund or two will put on this kind of trade. In no way are such trades a sign that bond investors are worried about the company’s future: in fact, bond investors are not the kind of investors who put on this trade at all.

And so, as Merkel says, reporters should be very wary indeed of drawing too many conclusions from movements in the illiquid CDS market. Sometimes, they really don’t mean anything at all.


Yeah, I think you are right. Might need to update regulation to handle CDS, though. They aren’t quite congruous to options.

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How QE works

Felix Salmon
Nov 4, 2010 16:56 UTC

Gawker’s John Cook asks me a question about how the Fed’s quantitative easing is supposed to work:

So the Fed is going to by $600 billion in U.S. Treasuries. It will presumably buy these Treasuries from private investors and institutions who had already purchased them–in other words, it won’t be handing $600 billion to the U.S. Treasury in exchange for bonds.

The purchases will be in increments of $1 million. Now, the kind of people who own $1 million and more in U.S. Treasuries tend to be people with a lot of money. And that money was kind of sitting there, and for some reason or another they decided to put it into treasuries, right?

So now along comes the Fed and says to those private investors and institutions, “Hey, I’d be happy to convert those treasuries into cash for you!” And they negotiate over price or there’s an auction or whatever, and the investors get their cash and the Fed gets its treasuries.

And so then these private institutions and investors are sitting there with a pile of cash. So why wouldn’t they just buy treasuries with it, which is what they had previously decided would be the wisest thing to do with that money?

The idea is to get those people to spend that cash in stimulative ways, right? But shouldn’t we assume that people who are sitting on large quantities of treasuries are sitting on them for a reason, and would likely continue to sit on them, even if they suddenly came into some cash?

John has a few of the details wrong, but at heart he’s absolutely right. The way that QE works is that the Fed will publish a schedule of how many Treasury bonds it intends to buy and when. It will then go out and buy those bonds from “the Federal Reserve’s primary dealers through a series of competitive auctions operated through the Desk’s FedTrade system.”

In English, what that means is that the New York Fed has a direct line to the biggest banks in the world (Goldman Sachs, Morgan Stanley, Deutsche Bank, etc — 18 in all). And it gets all those banks to compete with each other, either directly or on behalf of their clients, for who will sell the Fed the Treasury bonds it wants at the lowest price. The winners of the auction get the Fed’s newly-printed cash*, and give up Treasury bonds that they own in return.

The people selling Treasury bonds to the Fed, then, are big banks, who are told in advance exactly how many Treasury bonds the Fed wants to buy. As a result, they’re likely to buy Treasuries ahead of the auction, with the intent of selling them to the Fed at a profit. This is pretty much what John said would be going on, only they buy the bonds before the auction, rather than afterwards. Once the banks have made that profit, it’ll get paid out in bonuses to the people on the bank’s Treasury desk, with the rest going to their shareholders. We’re not exactly helping the unemployed here.

More generally, the Fed isn’t going to be buying any more bonds than the Treasury is issuing — so it’s not going to be lifting a lot of holders of Treasury bonds out of their long-term investments. But insofar as the Fed is forced to offer such high prices that investors simply can’t say no, those investors are probably just going to take the proceeds and invest them in agency debt instead from Fannie Mae and Freddie Mac. That debt is just as safe as Treasuries, and it even yields more than Treasuries, to boot.

What’s emphatically not going to happen is that the people who used to own Treasury bonds will take the Fed’s billions and suddenly turn around and spend them buying croissants at their local family-owned bakery. We’re talking about monetary policy here, not fiscal policy: the aim here is to bid up the price of Treasury bonds, which means that the yield on Treasuries will fall, and that those lower interest rates will somehow feed through into greater economic activity. The aim is not to take $600 billion and spend it on stuff in the real economy. That would be a second stimulus, and the chances of a second stimulus right now are hovering around zero.

Which is why Brad DeLong puts the value of buying $600 billion in Treasury bonds at about $7 billion in total, rather than anything near the headline $600 billion figure. The Fed is playing around with interest rates here — that’s its job. It’s not trying to directly stimulate demand.

*I should also take this opportunity to answer a question from CJR’s Dean Starkman, who asks where the money is coming from. The answer is that in a fiat-money system such as ours, the central bank can simply print as much money as it likes. If it wanted, it could literally go down to the local printing press, print out a bunch of $100 bills, put them in armored trucks, and send them over to JP Morgan or whoever sold them those Treasury bonds.** But that would be silly. So instead it simply increases the amount registered as on deposit at JP Morgan’s bank account at the New York Fed.

If JP Morgan had $100 billion in that bank account before, and then sells the Fed another $50 billion of Treasury bonds, then the Fed will just credit that $50 billion to JP Morgan, and the new balance in JPM’s account is $150 billion. Central banks can do that, which is why they’re so powerful. The amount of money in the system has just increased by $50 billion, and the Fed hopes that somehow that increase will feed through into higher inflation. Whether it will or not, however, depends on the degree to which JP Morgan can take that $50 billion and lend it out into the real economy. So far, banks have been bad at boosting their lending. And there’s not a lot of evidence that they’re getting any better.

**Update: Alea tells me I’m wrong on this: it’s the Mint which prints paper money, not the Fed, and all paper money is backed by Treasury-bond collateral.


Alea is incorrect. The Dept of Treasury’s Bureau of Printing and Engraving prints paper money on behalf the Fed (and netting 4 cents a bill regardless of denomination). The US Mint is a separate Treasury agency that coins money. Coin money is a different kettle of fish, the Fed buys coin from the Mint at face value. The Mint’s costs stay in its Public Enterprise Fund, the Secretary of Treasury sweeps the profits into miscellaneous receipts (31 USC 5136) So every dollar coin that costs 12 cents to mint adds 88 cents to general revenue.

The Secretary is granted authority to mint platinum coins of whatever “specifications, designs, varieties, quantities, denominations, and inscriptions” that he prescribes (31 USC 5112(k)). As we saw with the dollar coin, a coin’s face value bears no relationship to its cost of production. Remember too, coin seigniorage is booked as revenue, not debt. A trillion deficit could be covered tomorrow by the Secretary directing the Mint to coin a $1 trillion piece (or ten $100 billion coins, easier to make change) and then showing up at the drive-in teller to make a deposit (the interest on reserve payments enable the Fed to peg the federal funds rate without having to sell Treasuries to drain excess reserves).

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The Dow yields more than 10-year Treasuries

Felix Salmon
Jul 1, 2010 15:37 UTC

Calculating the dividend yield on stock indices is more of an art than a science, since no one knows for sure exactly what dividend the stocks in any given index are going to pay over the next year. But one good estimate puts the dividend yield on the Dow at 3.1%, while Eddy Elfenbein has calculated it to be 2.9%. Either way, it’s higher than the current yield on the benchmark U.S. Treasury bond, which was last seen at 2.89% and falling.

What this means is that if the Dow’s stocks, and their dividends, go absolutely nowhere over the next 10 years, they will still outperform Treasury bonds. Which doesn’t necessarily make either asset class a good investment: it’s entirely possible that both stocks and bonds are going to go down rather than up over the next decade. But it does say to me that stocks are increasingly attractive, on a relative basis, when compared to bonds. And if you’re valuing stocks on some kind of discounted-cash-flow basis, then your valuations should be soaring right now, as long-term interest rates continue to fall. Which probably just demonstrates the limitations of DCF analysis more than anything else.


If you like the dividend yield now, just wait six months. It’s about to become _awesome_. Or at least that’s my bet.

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