Tag Archives: bubble

Revised: How to Deflate the Education Bubble

In the last 15 years, outstanding student debt in the United States has grown from $240 billion to an astonishing $1.2 trillion, driven largely by rapidly accelerating tuition rates.  During the same time period, average wages have only grown a mere 10%, making student debt an increasingly uncomfortable topic.  In fact, JP Morgan deemed the student loan market so overladen with risk that in October of 2013, the firm stopped issuing any additional student loans.

Based on these signs, I agree with a recent Huffington Post article that relates the higher education bubble to the housing bubble America experienced in 2008.  The loose lending standards (low down payments), securitization of mortgages (MBS), and high levels of speculation (overwhelming belief that the housings values will continue to rise) that contributed to 2008 bubble burst all have parallels in the higher education market.  Many students pay no downpayment and have poor (if any) credit history.  Student loans are being packaged and resold as student loan asset backed securities (SLABS) to hedge lender risk.  And despite the 44% undermployment rate of young college graduates, most Americans continue to believe that a college education is an ideal (if not necessary) investment.  All these factors suggest another bubble is about to burst, and in an attempt to offer a partial solution, this post will focus on the speculation involved in the higher education market.

However before considering a solution, it is important to first understand the route cause of asset bubbles.  In A Random Walk Down Wall Street, Burton Malkiel makes the cause of asset bubbles very clear in his explanation of the tulip-bulb craze that plagued Holland in the early 1600s.  After the mosaic virus created striped tulips in the late 1500s, Dutch citizens desperately wanted the most unique tulips in their gardens, and they were willing to pay a handsome premium for them.  As more and more people bid up the price of tulip bulbs, more and more believed these bulbs were a smart investment.  Indeed, by the 1620’s people were selling their jewels, furniture, and even land to buy tulips!  Nevertheless, no bubble can grow forever, and in February 1637, Dutch public opinion changed.  The price of bulbs fell more than 20-fold that month, and despite the government’s best attempt to prevent a sell-off, the bulb bubble burst, leaving an abundance of disappointed and bankrupt investors.

The Tulip-Bulb craze perfectly illustrates the result of what Malkiel refers to as “Castle-in-the-Air” investment theory.  Under this theory, an investment’s value is based on public opinion, and decisions to buy and sell are based on random guesses about changes in public opinion.  When public opinion changes, bubbles can burst and investors can suffer huge losses.  In my opinion, the “Castle-in-the-Air” investment theory applies perfectly to college education (tuition costs are rising despite the fact that tuition benefits, ie: employment and wages, are falling).

I’d argue, and I think Malkiel would agree, that a switch in investment theory could reduce the risk of asset bubbles.  In addition to “Castle-in-the-Air” theory, Malkiel also explains  the “Firm-Foundation” theory, which is an investment strategy based on the intrinsic value of investments.  When the price of an investment is less than its intrinsic value, you should buy; when the price is more than intrinsic value, you should sell.  Because this form of investing is based on data and not public opinion, it is arguably less susceptible to speculative attack.  Indeed, Malkiel points out that firm-foundation investing is how Warren Buffet made his fortune.

It therefore seems that to reduce the risk of a student loan bubble, we need to switch investment in higher education from a “Castle-in-the-Air” model to a “Firm-Foundation” Model.  But how?  I believe the answer lies in a recent Wall Street Journal article.  In “Colleges Are Tested by Push to Prove Graduates’ Career Success,” author Melissa Korn points out a trend in prospective students requesting information on graduates’ salaries.  Given that college is an investment (that should generate a real return after an initial payment), this request seems extremely logical!  Why would anybody spend $200,000 on out-of-state tuition at UM without assurance (or at least data supporting) a sizable income stream after graduation?

If firms are required to release GAAP-audited financial statements to give prospective investors a prediction of future cash flows, I believe universities should have to do the same.  While there is currently significant push back from universities to release this data, I think that reporting graduate salaries based on school, major, GPA, etc. is an essential step in changing college education from a “Castle-in-the-Air” investment to a “Firm-Foundation” investment.  (The implications of this are consequential indeed, as it would likely force the cost of well-paying majors like business and engineering higher than the cost of low-paying majors like anthropology and agriculture.  That said, this is a consequence that is completely in line and appropriate given a “Firm-Foundation” investing environment, and it is one that I am comfortable with.).  Personally, I believe if we can successfully alter the way students choose to invest in college education (by reducing speculation), we can effectively reduce the risk involved in student loans and prevent student debt from repeating the Dutch Tulip Crisis and pushing America back into recession.


So, Is It Really ’99 All Over?

Having been thinking about the lessons from Burton Malkiel’s, A Random Walk Down Wall Street, over the last couple of weeks, one of the more interesting conversations in the book has to do with his analysis of bubbles, more specifically the 1999 “Dot-Com” Bubble and how it was essentially the summation of all of the other irrational bubbles that had existed before it. Malkiel takes the position that again and again the market has recognized these bubbles and corrected them before too long. This stance got me thinking about where the markets are right now amidst a glut of IPO’s in the recent weeks, some of which are just not very profitable.

Business Insider’s Joe Weisenthal came to my rescue and completed an interesting analysis between last weeks big IPO: King Digital Entertainment or to everyone in the non-finance world– the maker of Candy Crush. KING made its debut last week with an IPO with a $22.50 book price; after the opening of trading the stock fell a combined 18% in its first two days of trading. KING makes money on its in app purchases and advertising in the games as well and made some $560mm in profit last year. (WSJ) The issue critics debate about is whether or not they will be able to repeat this type of performance in other games or whether or not they are a one hit wonder type of company.

Weisenthal strikes the comparison between KING and the wild 1999 IPO of Sycamore Networks (SCMR). SCMR opened up trading between $200 and $250 during the day and closed with a price of $184.75 which equated to a $14.4bn market cap. With that type of price one might think that this was a decently profitable company– this was far from the case– the company had $11.3mm in revenue the year before and posted an operating loss of $19.5mm. SCMR had… (prepare yourself)…. one contract which made up the entirety of their business operations. This equates to a a price to sales ratio of 1274x. In comparison KING only has a price to sales ratio of 3x with a market cap of $5.7bn against $1.8bn in revenue.

Obviously this is a very minute sample of amongst all of the IPO action in cloud based software, biotech, etc today, but I think it makes a couple of important points. First off, while companies may be trading at pretty large multiples today, There are not many examples of price ratios of over 1000. Secondly I think the markets that these companies are debuting in are much better defined today than they were in the dot-com era; people have a good idea of what cloud computing and software is as well as making money from e-marketing (see FB and GOOG). I do agree the the market will correct the prices of some of these names that are not making money, but for the moment I think the trend is more geared to these companies trying to make some money while their markets are hot, but this time investors are asking them to show them the money.

Further more I do think that Burton has things right when he says that the market will correct these prices eventually, I think this is true in any market you look at. The question just comes down to a matter of time.

Government Intervention in Bubbles

Upon completion of Burton G. Malkiel’s A Random Walk Down Wall Street, I was thinking about the various bubble scenarios listed throughout the first part of the book, where investor’s were betting on “castles in the air” hoping that a greater fool would come along to pass their overpriced stocks to. At one point when discussing the “tronics bubble” in the 60’s, Malkiel quips that the SEC never got involved in the massive speculation because they couldn’t force people not to throw their money into these overpriced stocks.

When I read that, I remember wondering if there are any other countries where outrageous speculation is curbed by regulators. The only example I could think of is the KRX in South Korea, where there is a daily price limit. Since 1998, a stock traded on the KRX is not allowed to fluctuate by more than 15 percentage points on any given day. Before that, there were even stricter limits. While this doesn’t force investors to make sound investment decisions, it does prevent the “castle in the air” from crashing to the ground before they can do something about it. While Malkiel mentioned stocks fluctuating over 50 percent a day during some bubbles, it would take 3 or 4 days before an asset could fluctuate that much on the KRX exchange.

While this obviously puts a limit on daily volatility, I was wondering if this kind of regulation would cause the stock prices to fluctuate less when looking at a longer time horizon. I checked google finance (which for some reason, only gives data on the KRX since mid 2005). The KRX actually dropped more during the 2008 financial crisis, although it also recovered quicker and the returns in the KRX index have been greater than any of the three major U.S. exchanges’ indexes.

This also led me search for other countries that have similar regulations on assets. I found examples where there are daily price limits on futures and options, but none for the securities themselves. Whatever the case, I thought the book was very easy to read and provided good, memorable examples. If I took anything away from the book, it is that I hope to hold assets in the future that don’t need daily price limits to not fluctuate more than 15 percent per day and that slow, boring, steady returns are much more desirable. From the litany of bubbles in the past, it also aptly demonstrates that human’s desire for rapid wealth creation will ensure that bubbles are not something that will go away.

(Revised) Will the Real Estate Bubble Burst in China?

It’s always the hottest topic among Chinese people about the real estate price since the bubble is becoming bigger and bigger since the 1990s. In this blog, I will explore what people think about the real estate bubble, what efforts the government is taking and provide possible assumptions about whether it will burst or not in the end.

Not like US, you cannot even imagine that for the majority of Chinese people they couldn’t even afford a house after working hard for the entire lifetime based on current real estate situation. The fact is that China’s real estate price have been undergoing a lot of changes with prices soaring in the past we now see an environment of declining prices. This phenomenon let investors question: will the real estate bubble really burst in China? (China’s Home Prices Rise to Record Levels)

I have to mention the definition of the bubble here: an unsustainable rise in the price of an asset, well above the market price given fundamentals. The bubble was indicated by three indicators: gap between disposable income and home prices, rising inventory and number of properties per person.

To save the market, right now Chinese government is taking great efforts from both policy and investment sides. From policy intervention, they have had four stages. From 1998 to 2003, they regulated and supported the under developed housing market. From 2003 to 2008, they curbed the rising housing price. From 2008 to 2009, they stimulated the housing market during the recession. And from 2010 to 2011, they took actions to prevent the rising bubble. From 2012 till now, they are stimulating the housing market again.

To indicate the future of the real estate, I’d like to mention the property tax pilot program which I think is pretty useful seen in the market. The program asks for more tax if you buy more houses in China. And it’s started in Shanghai and Chongqing already. (Many Chinese Welcome Idea of Property Taxes)

Also, as the mature of China’s financial market, people might be less likely to purchase houses because they would have more options for investment in future.

From population side, statistics show that the population will reach the peak in 2018 and labor force will shrink from 2015. Thus people predict that the property prices will start to fall between 2017 and 2018 thanks to the “one child policy” and China’s aging population composition. According to this information, pessimists predict a 40% decrease in the next five years since there will be fewer people willing to purchase a house but the supply is still large. Anther great concern of mine is the money chain of the real estate company because the majority of them burn a large percentage of loan. Once the supply is bigger than the demand, they’ll face a money chain rupture. They have to decrease the price attracting more buyers to save the company.

But optimists insist that the prices won’t decrease a lot due to the large population and demand in China. They also mentioned that right now in the bubble, China’s residential mortgage debt was only 15% but U.S. always has a mortgage rate as high as 80%. (Why China’s property market isn’t in a bubble)

Prices might be controllable in future thanks to the government policies but so far, recent policies have not been given deadlines. In short run, volatility may be seen due to uncertainty and in long run, there’s still a question for us to see whether the bubble will burst or not.

No free money anymore for buying Yuan

A sharp and sudden slide in China’s yuan is forcing investors to rethink one of the most reliable trades in financial markets over the past four years: betting on gains in the Chinese currency.

Over the past 8 years, yuan has strengthened by about 33%, making  investing in yuan related derivatives an almost free money to invest in for both institutional and individual investors. Chinese exporters have been big buyers of derivatives because they allowed them to hedge against the rising yuan. In many cases, the businesses are losing money in their operations but make profits because of the hedges, which generate a monthly income.

However, last week, guiding by the PBOC, renminbi dropped to its weakest level in seven months.The easy money gets tougher. 

The earliest reaction was this recent decline in the yuan reflects economic fundamentals, based on the fact that GDP slowed to 7.7% in the fourth quarter from 7.8% in the third quarter.But the fact that the exchange rate in China is not determined by the market rules out this possibility. For people who may not know about China’s foreign exchange regime: the exchange rate was determines by China’s central bank based on a basket of currency (including USD). Specifically , a reference point for the yuan is set daily and then lets it trade 1% higher or lower.  So the change in yuan is basically still driven by policy makers rather than market forces, although few people willing to admit that. 

From my point of view, there is at least tow reason why PBOC alter the trend of RMB movement.

The first being to shake out speculators as China prepares to allow a wider trading range for yuan, an essential step toward Chinese foreign exchange reform.Recent years, there has been a huge inflow of speculative money (or hot money ) to take advantage of both rising Yuan and higher interest rates. This could be problematic for China, whose central bank takes control over the exchange rates. To stabilize the exchange rate, PBOC and its state-owned affiliates has to absorb dollars, making China’s foreign reserve explode over the past few years. Meanwhile, inflation arise as banks exchange dollar into RMB and dumped them into the market. This has caused huge inflation and asset price bubbles in China.To curb the inflation and implement the long overdue exchange rate marketization, China is now trying to depreciate yuan and shake off speculative money from the system to  improve financial stability. China would need a more stable environment to unfold the exchange rate reform.

The second reason being to prepare for a foreseeable economy downturn brewing so long in China. It is known that China’s shadow-banking imposed a huge threat on the financial system of China. As QE retreating, hot money used to boost the irrational exuberance in asset market will retreat as well. The burst of bubble would obviously result in a huge economy downturn in China. Therefore, the only quick solution to prevent economy from recession would be to increase export.

Fisher equation and the paradox of bitcoin

There is no lack of comments about the significance of Bitcoin. Some treat Bitcoin as an apparent speculative fad, while others argue that Bitcoin could become as revolutionary to monetary system as email is to information system. Being bombarded by all kinds of assertive ideas and well-structured arguments, I think it is crucial to have one’s own stance on this issue. According to what I have learned about currency, bitcoin is losing its function as a transaction media and evolving into a speculative tool. If a currency is not transferable and become an speculative tool, sooner or later the use of this currency will die out.  Once the bubble burst, this super nova will step down from the stage of history .

Over the past three years, bitcoin’s price skyrocketed from a few cents in 2011 to a high of more than $1,100 in December 2013. As a electronic currency, bitcoin does not really need to posses any intrinsic value to be exchangeable. But the surge of price from a few cents to more than a thousands is evidence that people are not using bitcoin as a means to facilitate exchange. Rather, this surge of price could only be explained by speculative activity.

To illustrate my point using fisher equation, now imagine we are all citizen in a nation that use bitcoin as official currency, and the only goods being exchanged in the economy is U.S. dollar.Recall how the face value of a certain type of currency is determined. By fisher equation, we have:  M*V=P*Q


M is the total bitcoin supply in the virtual nation

V is the number of times per year each bitcoin is spent (velocity of money),

P is the average price of all the good (i.e. U.S dollar) sold during the year, denoted in bitcoin, of course

Q is the quantity of goods (U.S. dollar) sold during the year.

supposed that we fixed M (this is realistic since the anonymous creator of the currency capped the number of total possible Bitcoins at 21 million). How will the price of our dollar change in response to change in  Q and V ?

Suppose now we have more dollar in the economy (or more dollar poured into the economy by some magical power, you could also see this as more people buying bitcoin using dollar from outside of the economy), then the quantity of dollar (Q) increased overtime. Holding other variables fixed, to make the equation balanced, we now have a smaller P.

Now suppose people preferred to hold the bitcoin in reserve than to frequently trade it for dollar, we now have smaller V.  We can see this as analogy to people in this virtual economy becoming less and less inclined to consume goods (dollar) that they “produced”. As V decreases, to make the equation balanced, we now have even more smaller P.

This is exactly what we see in reality. More and more people buy the fixed amount of bitcoin and hold it on reserve, waiting for appreciation of bitcoin rather than using it as a transaction media.  Therefore,  we see the price of dollar denoted in bitcoin become smaller and smaller, or put it another way, the price of bitcoin denoted in dollar become larger and larger.

This illustration is to support my argument that bitcoin is not used as a supplements to facilitate transaction, as it is originally intended for, but rather as an speculative assets.

The most important reason bitcoin become popular is because people believe it will replace traditional currency due to its merit of reducing transaction cost. But it is paradoxical to see that the bitcoin, while being valued for its merit of facilitating transaction, is gradually stepping out of circulation and ended up in investment portfolio. This paradox helps me explain my stance on bitcoin nature, a splendid castle-in-the-air that will gone with change sign of economy weather.


An advice: stop accepting advice.

There is one interesting article that I found on WSJ talking about how some advices are useless. The author Joe Queenan satirize on people’s inclination of seek advice that is not constructive, and providing advice that are unsolicited.

Why advice is worthless to follow? Here are some reasons for this that personally think is true and some I borrowed from Joe.

First, the person who provide advice might not be an expert,  in terms of both the thing he recommended for you and your very situation. In the latter case, he might never really know your situation. In the former case:  if he is  not an expert, find someone from McKinsey or find Warren Buffett(provided that he had time to think on your trivia and you can pay for his millions worth of words on a regular basis). The more important reason why there isn’t a lot of useful advice and reliable information is because information is mostly asymmetric, and the word flowing around seldom comes from the wise.  If someone know the truth, why they want to share with you?

I know this may sound extreme, there is some people so benevolent to share with your exciting truth. But once the truth is out there, will people respond actively to the advice? The more likely case is that people who seek advice already make their decision. Some people ask advice until getting the word they want to heard.(AKA. Confirmation bias rules) For example, you already know that you’re going to give up your job on Wall Street, but you solicit a bunch of other advices, such as your health, your quality time with family,   just to make your idea look good.

Thirdly, as Joe put it, “Success on anyone’s terms other than your own is failure.” This is because accepting too much advice make you lose sight of your speciality and uniqueness and eventually make you a common person that fit into the norm. The only way to succeed is not to seek(a lot of ) advice, but to try to find the truth on you own. This would certainly cause a lot of failure and rejection in the beginning, but good advice almost always comes in the form of rejection, that is when you will actually learn something new.

In the first several chapter of the book, Random Walk Down Wall Street by Burton Malkiel, the author listed several big bubbles in the history. The bubbles have a same pattern to trace: people follow advice from someone who themselves have no idea of what they are talking about, and then they pass that advice on to the next person. It is amazing to see how people know it is a lie while they continue to pass the lie to the next person. We can see from those cases how unreliable some word of advice is.



Stock Bubble Bursting

The stock market has taken a tumble in recent weeks; the DJIA is down 6.5% in the past month.  Global markets have also had a rocky stretch, most notably the emerging markets, which have been on edge for several weeks as a result of poor growth news in China and the Fed’s continued taper.  First, we will examine some possible reasons for the decline in stock prices, and then we will think about the consequences (and benefits!) of such a sharp drop.

The first question to answer is: why have stock prices declined so much, so quickly?  As always, there is no one reason why stock prices have behaved precisely the way that they have.  However, there seems to be a general erosion of confidence in the market.  The December jobs report wasn’t as good as the numbers looked, with a large decrease in work force participation. Other indicators of a healthy economy, such as the Institute for Supple Management purchasing managers index, dropped sharply in January.  Combining these with tapering stimulus from the Fed, and confidence in the market is a long way from the optimism of December.

Another explanation for current decline is that stock prices rose to unsustainably high, or perhaps unreasonably high during the end of 2013.  As one market analyst pointed out, “You didn’t have to be real smart in 2013 to make money. You just didn’t want to get in the way of the Federal Reserve.”  Many others believe that the market is in a bubble phase as well.  One indicator of bubble level prices is the total-market valuation to GDP ratio, which recently was at an all time high before the current top in stock prices.  The S&P 500 gained an astounding 30% last year, riding on the back of the extremely stimulative monetary policy set by the Federal Reserve.  Thus, the roots of the current downtrend of the market are not the Fed taper or disappointing measures of growth, but instead an overpriced market just waiting to fall.  Perhaps the loss of confidence provided by these negative shocks to the economy were enough.  As one analyst puts it, “For people who were a little bit skittish and looking for reasons to doubt the market, they found some support in that data.”

What is the result of such a decline in the stock market?  First, as the stock market appears to be more risky, the price of 10-year treasury bonds rose to an all time high (and thus the interest rates were at an all time low.)  One analyst says,

“The behavior change now is people are absolutely paying attention to fundamentals”.

This statement I think is very important for two reason, one present, and one future.  First, this is a present statement of admitting that stock prices are probably too high.  The overall valuation of the market grew a bit too optimistic towards the end of 2013 and now because the recovery of the U.S. economy has been slightly tarnished by new data, expectations are returning back to realistic levels.  Thus, in the short run I believe that investors will act with a little more caution, and be less bullish.

I think more importantly, such a widespread realization signifies that the U.S. economy is in good hands.  If everyone agrees that bubbles are bad things and that we should avoid them it would seem prudent to have a market that identifies before they get out of hand.  The end of the housing bubble required the collapse of a large financial institution, and the bailout of several others to be recognized, and caused the world economy to enter a multi-year downward spiral.  If the current stock market is a bubble, and those in the markets have recognized it, we have come a long way in the last five years as far as valuing good economic fundamentals with regard to pricing.  Therefore, I believe that the U.S. economy is in good hands for the near future.




Stonernomics – The Marijuana Stock Bubble

After today’s weak manufacturing report reflecting soft numbers in domestic factories, the DOW Jones took a 300 point hit.  As domestic stocks continue to struggle, marijuana stocks conversely have continued to explode this year following the legalization of recreational marijuana in Colorado. The legalization of marijuana in Colorado has many investors wondering if marijuana is going to be a legitimate growth investment in the future.

With the growing national support towards legalizing marijuana it is hard to see how the marijuana market will not grow in the future as more states continue to push for legalization. According to a recent Gallup poll, 58% of Americans were in favor of legalizing marijuana. Currently twenty states currently have laws allowing for legalized medicinal marijuana, with a few states having legislation on the table. Out of the twenty states with pro-marijuana laws, nine don’t yet have active retail markets. These factors have many analysts predicting strong growth over the next few years. A San Francisco cannabis industry group, ArcView Group, predicted that next year’s marijuana industry revenue will be up 64% to $2.34 billion. Furthermore, MMJ Business Daily predicted that legal cannabis revenue will be between $4.5-$6 billion by 2018, up from $1.3-$1.5 in 2013. (WSJ – Entrepreneurs Seek Profits from Pot) With all this being said are the current marijuana investments available in the market prudent investments?

The answer to the question is undoubtedly no! Out of 35 public listings of marijuana companies available domestically the majority trade over-the-counter or on the pink sheets and are being pumped online by the stoner version of Jordan Belfort. According to Alan Brockstein, a self-proclaimed marijuana stock expert, “most of these stocks are not good investments.” (The New York Post – Pot Stocks May Go Up in Smoke) Fueled by a high demand and no real supply, many of these marijuana “companies” are figments created by stock-promoters to fuel the rising marijuana demand in America. These marijuana stocks are mostly shell companies that through acquisitions have obtained “marijuana related” companies with little exposure to the actual medicinal drug.

For example, popular marijuana stock Terra Tech (TRTC) is trading up over 250% for the year. The majority of Terra Tech’s revenue from its latest report came from its vegetable garden subsidiary, yet the stock more than doubled following the legalization of recreational marijuana in Colorado. Similarly, Growlife Inc. (PHOT) an owner and operator of 5 hydroponic retail stores is being valued with a market cap of $230 million, or $46 million per store.  Despite these companies being vastly overpriced and in reality having limited exposure to legal marijuana revenue, the prices of their shares shot up exponentially as investors watched and read about recreational marijuana in Colorado.

As media coverage of Colorado ends and stock promotions run out, these marijuana penny stocks will inevitably fall and 2014 will go down as the year of the marijuana stock bubble. Despite many traders raking in money as a result of the bubble, long term investors will likely find disappointment when they see that their investments go bankrupt.

The Fed and a Bubble: Flashback to 1927-1930

In recent discussions around effects and consequences of the Fed’s monetary policy, a bubble in stock market has attracted attention. Even though the Fed’s conventional and unconventional easy monetary policy, along with fiscal policies, has been keeping the U.S. economy from slipping into another Great Depression, unintended consequences of the Fed’s recent policy, specially QE3, could be a big problem on its own as the policy sustains the recovery. The full effect of QE on the economy and the financial system isn’t still fully known. Victoria McGrane quotes San Francisco Fed President John Williams from his recent paper on the zero lower bound:

Added to this uncertainty, the programs also raise “nagging concerns that large-scale asset purchases carry with them particular risks to the economy or the health of the financial system that we still don’t understand well,” he said.

Warning of a stock bubble has already been voiced by some of the Fed’s policy makers. They argue that today’s historically low federal funds rate has been fueling the stock prices. Therefore, they argue the Fed should pull back its bond-buying program to stop the potential stock bubble. However, the Fed shouldn’t, in my opinion, tighten its monetary policy  so quick to just stop any potential bubble.

Here, Economist‘s 1998 article, “America’s Bubble Economy”, says:

In the late 1920s the Fed was also reluctant to raise interest rates in response to surging share prices, leaving rampant bank lending to push prices higher still. When the Fed did belatedly act, the bubble burst with a vengeance. The longer that asset prices continue to be pumped up by easy money, the more inflated the bubble will become and the more painful the economic after-effects when it bursts.

Now, let’s try to see what was the Fed’s action in the years prior to the Great Depression. In 1927, the Fed decreased its federal funds rate in the face of a mild recession in the U.S. and Britain’s balance of payments crisis. Following this policy, the stock market prices gained 39% and the price-dividend ratio rose by 27% in 1928 (FYI: IN 2013, the Dow and S&P500 stock prices gained 26.5% and 29.6% respectively.) Worrying about a potential stock market bubble, the Fed raised the discount rate from 3.5% to 5% in the first half of 1928. The contractionary policy seemed to be working as the price-dividend ratio continuously fell until July 1929, when it started to increase again. Acting against this increase in the stock price, the Fed further increased the discount rate to 6% in August 1929. We know what happened next: the stock market crashed in late October of 1929. Here, we can see the Dow Jones Industrial Average price and price-dividend ratio in late 1920s.



As we briefly discussed the actions that the Fed took to cool down the stock market in the late 1920’s, we should study further what this Fed’s actions led to.

Today, the Fed faces the same problem even though Fed Chairman Ben Bernanke doesn’t see an evidence of a bubble. Therefore, today’s one of the biggest problems is whether the Fed can manage its bond-buying program in a way such that it’s action doesn’t burst or sustain any dangerous bubble.