How to bet against a bubble: the Ultimate Bottleneck strategy
May 25, 2010
The other night I had a conversation with a financier that offers some pointers for spotting trouble in the sovereign crisis. How, we wondered, does one bet against a bubble?
It is not at all obvious. There is the problem of betting too early. We recalled the case of an ex-colleague of mine, economics professor and expert on real estate. He sold his flat in Barcelona in the year 2002, on the conviction that real estate was overheated. He lost five years of upside, and would still be up today if he had not sold. Now, this is a real problem. You not only have to be right, but also timely. How do you pull that off?
After a bit of joking (and the first pint) we came up with what that could be called the “Ultimate Bottleneck” strategy. Say you think people are irrationally buying houses in the hope of reselling them for a profit… even as prices are far too high. When will that stop? Well, it’s difficult to know, because there is a positive feedback loop. Banks lend home buyers money to do the gamble, which drives prices up. As they go up, less credit worthy borrowers want houses. In 30 years, when the houses are sold, their investment wont be recouped. But for now, betting that the trend will reverse is very dangerous… because you’re betting against feedback loop. Feedback removes the “rubber band” that would otherwise pull prices back to normal.
So the right question should not be when will people regain sanity but rather, “when is this loop sure to stop”? When is it that a society of deranged individuals (even if such a thing existed) would no longer be able to sustain price growth? And the answer we came up with is — when people can no longer pay the monthly payments. The strategy is then clear: if you are in a bubble, assume it will continue for as long as the feedback loop holds. Locate the crucial juncture points in the loop. Determine which the weakest linkage. And use it to time the bet.
Consider the beauty of this reasoning. It is clear, measurable, tangible. And it connects beliefs about the long term with the reality of short term. I saw a similar dynamic in my study of securities analysts during the dot-com bubble, done with Raghu Garud. The debate over the long term future of Amazon.com (say, long-term revenue, or margin) was shaped by the analysts interpretation of short term events such as third-quarter sales. This temporal dynamic in the controversy over frames has not been explored elsewhere in the literature, and I think it is crucial.
The application to Greece and other sovereign debt countries is clear: watch out for the auctions of bonds. The application to Spain and house prices is equally interesting: prices have not come down as much as they should. With this in mind, it is interesting that the auction of treasury bonds in Spain did not go well at all last week. According to the Financial Times,
Spain came close to its first debt auction failure on Tuesday, highlighting the funding problems for weaker eurozone economies (…) The government’s difficulties in selling €6.44bn ($7.96bn) in one-year and 18-month bills sparked worries over its 10-year debt auction on Thursday (…) Steven Major, head of fixed income at HSBC, said: “The Spanish auction was very disappointing and does not bode well for further issuance. It’s becoming more apparent just how difficult it is for Spain, which is a big worry so soon after the launch of the international rescue package.