is this a bubble?

in my previous post "we're all gamblers," i made up an analogy using trains moving at different speeds to represent the different kinds of investments you can make. each train is a different thing you can be invested in, and you want to be riding on one which is moving briskly forward, not sitting still or, as is too often the case these days, going backward. the point i was trying to make is that, unless you are completely broke, as in homeless or thereabout, you are always riding on one or another of the trains. there is no "safe" position on the platform, as there was in the good old days. at some point in the future, i hope to sit down and look at each of the different kinds of investments and some of the ways to value them, to figure out what they are worth based on some quantitative measure, such as the interest or dividend or rental income which they earn. but there is a much more interesting element to all of this, and that is the psychological element.

it is my belief that people are not always rational when making investment decisions. they do not always assess the prospects for their choice with a cold and impartial analysis. there is a tendency to get caught up in some fad or hot investment, something which everyone is talking about around the watercooler or at parties. back in 2000, you couldn't go into a bar or restaurant without overhearing someone talking about their stock portfolio and subltly bragging about how well it was doing. six years later, everyone was flipping condos and discussing their latest deals.

once in a while, one of these fads can get completely out of hand and it becomes a bubble, or as it used to be called, a mania. there are stories that in the late 20's during the big stock market mania people were getting stock tips from the elevator operators and shoe-shiners. everyone was coming up with reasons why the world had changed in some fundamantal way to accomodate their view that stocks would continue to rise indefinitely. at times like this, when there is great excitement and everyone is making a lot of money, it is difficult to be a contrarian and to resist the urge to throw your money in as well. just about everyone knows that this big bubble ended with the great crash of 1929, and most of the people who made money in the bubble lost it all and more in the crash. i believe that our situation today is very similar to that of the twenties, and i plan to use it as a model in discussing some of the things which might happen in our future. of course there are differences, and i shall try to look at those as well.

returning to the present, we are in an interesting period, a sort of limbo. it seems clear that the real estate bubble has begun to burst. one way to see this is because everyone is now acknowledging that we have had a bubble, you can read about it in the daily paper or hear about it on tv, and you do not get that kind of insight when the bubble is still inflating. foreclosures are increasing at an alarming rate and people are losing their homes as well as their investment properties. i'm starting to read articles that say that things are so bad that we must be at a bottom, and that this is the time to start buying again for the next upturn. this certainly makes more sense than buying a year or two ago at the top, but is it a good idea?

if we return our attention to the 1920's and 30's, we may be able to gain some insight. we know there was a great crash in october 1929, in which stocks lost 30 to 40 percent of their value in just a few days. because of margin (the use of leverage to buy stocks with only 10 to 20 percent down), many people were wiped out then and there. in fact, part of the reason that the market fell so fast was that forced margin sales drove it down further than it might otherwise have gone. at that point, many people argued that this was a fantastic buying opportunity, that the conditions for stocks to keep climbing were still intact, and that there were great bargains available. and the market did rally from there, gaining back a good part of the loss over the next few months. after a while, though, the market started to go down again, passing the point of the original decline to a new bottom. again, the bargain hunters jumped back into the market and it went up again, but not so far as the previous time. this process went on, over and over, for a period of four years until, by 1933 the market had lost not 40 percent, but 95 percent of its value. yes, a thousand dollars worth of stocks was worth 50 dollars by the time the real bottom was reached. many companies went out of business and their stock went to zero, so there was no recovery for those stocks, ever. this was the start of the great depression, which made the great crash seem mild indeed.

i realize that i have not made a convincing case yet that our current situation is close to that of the 20's and 30's, but i will try to draw more parallels in future posts. in fact, i started out trying to do that, and i found it getting ponderous and boring, and never really getting to the important point i want to make. but i want to state clearly that i do believe that these situations are similar and that we may be facing an economic collapse which could be as serious as that of the great depression. and i do have a number of ideas about how one can protect oneself, and they don't all involve buying guns and burying gold in your backyard.

reader steven is justifiably impatient, wanting to know what to do about all this. and he asks, indirectly, the 64 million dollar question: can we expect the collapse to be inflationary or deflationary. i am still pondering this issue and thus will give it a lot of attention in future posts, as i reason it out as i go. but a quick answer is: i'm leaning toward deflation, so it might not be a bad idea to hold onto your cash. cash is, of course, one of the trains, and it hasn't done very well while everything else has been going up in the bubble. and US dollar cash has not done well of late versus other kinds of cash such as the euro and yen. tough question, but remember that when one of the trains lags behind the others for a while, it will often play catchup as the others slow down.

if you're interested in more information on bubbles and crashes, please read one of the books on my recommended reading list to get a more complete description of these phenomena.