Spotting Bubbles: Originally Sound Premise & Price Actions

I had read the attached really great testimony on Buffet when it first came up and found myself re-visiting it when talking about a bubbly market.??

 

I think most people are generally good at coming up with macro/micro themes e.g. Internet is going to change the world and people will buy pet supplies so lets buy pets.com OR Steve Jobs is a Genius so lets buy Apple. But training, experience and common sense will ask you to have valuation & margin of safety principles. The first sign that people are not inherently thinking of valuation is when they can articulate ENTRY points but NOT exit points.When you search Buffett’s testimony with FCIC and keywords such as “price action” in the document you see some of the following excerpts (the document has more and is a great read). Basically, you could argue that any bubble will have a ORIGINALLY SOUND PREMISE??(e.g. Real estate goes up, Internet will change the world, Developing economies etc…) but at what point is “PRICE ACTION” taking over?

So, If one can’t articulate ENTRY and EXIT points (& the economic basis for those entry/exit points), then how do we know when we have departed from the original sound premise and believing only in the price action.

50676366-Transcript-of-Warren-Buffett-Interview-With-FCIC

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The basic cause (of the subprime crisis) was, you know, embedded in, partly in psychology, partly in reality in a growing and finally pervasive belief that house prices couldn’t go down. And everybody succumbed, virtually everybody succumbed to that. But that’s, the only way you get a bubble is when basically a very high percentage of the population buys into some originally sound premise–and it’s quite interesting how that develops–originally sound premise that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action. So the media, investors, mortgage bankers, the American public, me, you know, my neighbor, rating agencies, Congress, you name it. People overwhelmingly came to believe that house prices could not fall significantly. And since it was the biggest asset class in the country and it was the easiest class to borrow against it created, you know, probably the biggest bubble in our history. It’ll be a bubble that will be remembered along with South Sea bubble and [unintelligible] bubble.

—–

So after a while the original premise which becomes sort of the impetus for what later turns out to be a bubble is forgotten and the price action takes

over. Now we saw the same thing in housing. It’s a totally sound premise that houses will become, worth more over time because the dollar becomes

worth less. It isn’t because, you know, construction costs go up. And it isn’t because houses are so wonderful it’s because the dollar becomes worth

less that a house that was bought 40 years ago is worth more today than it was then. And since 66% or 67% of the people want to own their home

and because you can borrow money on it and you’re dreaming of buying a home, if you really believe that houses are going to go up in value you buy

one as soon as you can. And that’s a very sound premise. It’s related of course, though, to houses selling at something like replacement price

and not [unintelligible] of stripping inflation. So the sound premise it’s a good idea to buy a house this year because it will probably cost more next

year and you’re going to want a home and the fact that you can finance it gets distorted over time if housing prices are going up 10% a year and inflation is a couple of percent a year. Soon the price action, or at some point the price action takes over and you want to buy three houses and five houses and you want to buy with nothing down and you want to agree to payments that you can’t make and all of that sort of thing because it doesn’t make any difference, it’s going to be worth more next year. And the lender feels the same way. Doesn’t really make difference if it’s a

liar’s loan or you don’t have the income or something because even if they have to take it over, it’ll be worth more next year. Once that gathers momentum and it gets reinforced by price action and the original premise is forgotten which it was in 1929. The internet, it’s the same thing. The internet was going to change our lives, but it didn’t mean that every company was worth $50 billion that could dream up a prospectus and the price action becomes so important to people that it takes over their minds. And because housing was the largest single asset around 22 trillion or something like on about, you know, a household wealth of 50 or 60 trillion or something like that in the United States, such a huge asset, so understandable to the public. They might not understand stocks or the internet, you know, they might not understand tulip bulbs, but they

understood houses. And they wanted to buy one anyway and the financing, and you could leverage up to the sky, it created a bubble like we’ve never seen. I wish I’d figured that out in 2005.

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Well, they didn’t anticipate, you know, how extraordinary a bubble could be created, you know. And very difficult to fault them because so few people

have a difficult time doing that when a crowd is rushing in one direction knowing the other direction is very hard. And usually the people that

do that become discredited by the price action, you know. If you were a Cassandra in 2005 or 2006 and houses kept going up, you know, after

a while people quit listening and it [unintelligible] because they’re nuts anyway, you know, anything that’s going on so you, you have a fringe element

to Cassandras too. Conceivably, you know, if the President of the United States, you know, or the Chairman of the Fed or somebody made a strong

statement, Greenspan made a strong statement I remember in 1996 you know about irrational consumers, you know, that didn’t stop the stock market. When people think there’s easy money available they’re not inclined to change. Particularly if somebody said a month or two ago watch out

for this easy money and then their neighbors made some more money in the ensuing month or two, it’s just, it’s overwhelming. And we’ve seen it.

 

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