Asset price bubbles

GameStop: Some Preliminary Lessons

Volatility in the stock market is not new. But, even if one takes a broad perspective, the recent experience with GameStop is extraordinary. As we write, the story is far from over, with several U.S. stocks—like GameStop, AMC Entertainment and Express—still on something of a wild ride. The Securities and Exchange Commission seems poised to investigate. And, members of Congress are planning to hold hearings. We don’t have any particular insights into how or when this will end. That is, except to say that history teaches us that episodes like this typically end badly.

Since this is an unusual post, we begin with a very clear disclaimer: nothing in this blog should be construed either as investment advice or legal advice.

In our view, we can already draw three big lessons from the equity market events of the past week. The first is about how narratives and the limits to arbitrage can lead to unsustainable asset price booms. Second, short sellers are important for the efficiency of asset pricing and the allocation of capital. Moreover, with the ongoing rise of passive index investing, their potential role in keeping the U.S. equity market efficient will become more, not less, salient. Third, to keep the financial system safe and resilient, it is essential that clearing firms maintain sufficiently stringent margin and collateral requirements even if, on occasion, it limits a broker’s ability to implement trades for its clients….

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Bitcoin and Fundamentals

Bitcoin is all the rage, again. Last week, the price rose above $10,000 for the first time. Following a Friday announcement by the Commodity Futures Trading Commission, the Chicago Mercantile Exchange, the CBOE Futures Exchange, and the Cantor Exchange appear poised to launch Bitcoin futures or other derivatives contracts, with Nasdaq likely to follow. Portfolio advisers are encouraging cryptocurrency diversification. In London’s Metro, advertisements assure potential investors that “Crypto needn’t be cryptic.” And, as skyrocketing prices gain headlines, less sophisticated investors are diving in.

The danger is that investors will interpret the surging price itself (and the associated hullabaloo) as a sufficient signal to buy, fueling an asset price bubble (and, eventually, a painful crash).

No one can ever say with certainty when an asset price boom is a bubble. Nevertheless, it makes sense to ask what fundamental services Bitcoin provides. More specifically, have the prospects for those services improved sufficiently over the past year to warrant the 10-fold increase in price that has vaulted Bitcoin’s market capitalization into the range of the top 50 U.S. firms?

We strongly doubt it....

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China: Deleveraging is Hard to Do

For the first time in nearly three decades, Moody’s recently downgraded the long-term sovereign debt of China, lowering its rating from Aa3 to A1. As is frequently true in such cases, the adjustment was overdue. Since China’s massive fiscal stimulus in 2008, the government has experienced a surge in contingent liabilities, as its (implicit and explicit) guarantees fueled an extraordinary credit boom that continues today.

While the need to foster financial discipline is obvious, the process will be precarious. Ning Zhu, the author of China’s Guaranteed Bubble, has compared the scaling back of state guarantees to defusing a bomb. China’s guarantees have distorted incentives and risk taking for so many years that stepping back and allowing market forces to operate will inevitably impose large, unanticipated losses on many people and businesses. Financial history is replete with failed policy efforts to address credit-fueled asset price booms, such as the current one in China’s real estate. There is no safe mechanism for economy-wide deleveraging.

China’s policymakers are clearly aware of the dangers they face and are making serious efforts to address them. This year, authorities have initiated a new crackdown aimed at reducing the systemic risks that have been stoked by the credit boom. This post focuses on that policy effort, including the background causes and what will be needed (aside from good fortune) to make it work....

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Regulatory Discretion and Asset Prices

The Federal Reserve’s annual stress test is the de facto capital planning regime for the largest U.S. banks. Not surprisingly, it comes under frequent attack from bank CEOs who argue, as Jamie Dimon recently did, that “banks have too much capital…and more of that capital can be safely used to finance the economy” (see page 22 here). From their perspective, this makes sense. Bank shareholders, who the CEOs represent, benefit from the upside in good times, but do not bear the full costs when the financial system falters. As readers of this blog know, we’ve argued frequently that capital requirements should be raised further in order to better align banks’ private incentives with those of society (see, for example, here and here).

A more compelling criticism of central bank stress tests focuses on their discretionary character. To the extent feasible, central banks should minimize their interference in the allocation of resources by private intermediaries, allowing them to direct lending to those projects deemed to be the most productive.

But the painful lessons that have come from large asset price swings and high concentrations of risk provide a strong case for the kind of limited discretion that the Fed uses in formulating its stress tests. This blog post highlights why it makes sense for regulators to use this year's stress test exercise to learn how well the largest U.S. intermediaries would fare if the recent commercial real estate price boom were to turn into a bust....

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Residential real estate in China: the delicate balance of supply and demand

When President Nixon and Chairman Mao shook hands in Beijing in 1972, only 17% of the 862 million Chinese lived in urban areas and the entire stock of housing was state owned. Today, more than half of China’s 1.4 billion residents live in cities, while 9 out of 10 households own their homes. Unsurprisingly, this housing revolution has brought with it a property price boom. Over the past decade, urban land prices have risen more than four-fold, with high flyers like Beijing surging by a factor of more than 10 (for the data, see here).

Will China follow the same path the U.S. took in the last decade? Will China’s boom turn into a bust?...

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Should I buy or should I sell?

The U.S. stock market dropped last week, but the S&P 500 index is still 13% above its year-ago level and a whopping 181% above its March 2009 trough. If you are an investor, your goal is to buy low and sell high. Looking at the stock market, what would we do today?  Are prices too high? Are they too low? Or, are they just right?

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Bubble, Bubble, Toil and Trouble: What's a policymaker to do? 

With key central bank policy rates stuck at the zero bound (or below!), investors in Europe, Japan, and the United States are searching for yield under every rock (see, for example, the charts below on S&P500 prices and earnings). That is, they are willing to accept small gains on their investments because they see little risk that their cost of funding will rise significantly for a long time...
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