Spotting the Next Bubble, Part One

Two troubling effects of government intervention gone awry are broad, economy-wide price increases and severe bubbles.  Bubbles are short bursts of exuberant spending, followed by deep contractions and rising unemployment.  When a bubble bursts, we find little or no sustainable wealth was generated, and losses are spread throughout the economy.  Bubbles happen in a free market, but are generally smaller, because they’re driven by demand for a particular commodity (houses, oil, gold, tea, diamonds, tulips, etc.), rather than a significant increase in the supply of money throughout the economy.

In our economic system, these bubbles are very destructive events: the Great Depression was fueled by such a bubble.  However, you can make a wicked profit when a bubble “pops” if you catch it in progress and have money to spare.

When the Fed prints money, wealth is reallocated from savers and creditors, whose returns are hurt by the inflation.  That wealth flows to borrowers, who can borrow money at cheaper rates with more of it in the system.  The borrowers’ spending of the savers’ borrowed money provides the economy a brief shot in the arm, but sets off a chain reaction that is the beginning of a bubble:

1. There are new dollars chasing the same old resources.  Producers’ costs for “inputs” like land, raw materials and fuel begin to rise.

2. Producers eat some of the cost increases, but eventually begin passing the hikes onto consumers.

3. Consumers demand wage increases, and employers provide them as reasonable.

4. Consumer prices begin to rise faster than incomes, eventually pinching consumers’ ability to pay.

5. Consumers, unwilling to abandon their borrowed standard of living, tap savings to pay for it, eventually exhausting their resources or their tolerance to spend.

6. Consumers begin to rebuild savings or liquidate debt.  Prices enter a free fall.  The businesses, jobs and infrastructure created to serve the bubble’s consumers evaporate.

7. Recession begins anew as workers skilled in the bubble trade(s) can’t find jobs at their previous wages.

Spotting an in-progress bubble is an art, but the idea is simple: an industry or economy with prices rising faster than spending power over an extended period is most likely in a bubble.  The tail end of a bubble will often be marked by a low (and declining) savings rate, as well. If you see both factors, look out below!

You can profit from a bubble by looking for “short” or “inverse” funds in the area of the bubble.  These funds bet that the value of a particular stock, bond or other asset will drop rather than rise.  If you’re expecting a recession soon (as I am) it’s a wise idea to load up on these funds.  Stay away from “ultra” or “leveraged” funds, though, unless you really know what you’re doing.  These funds borrow money to bet on a quick drop, so unless you’re expecting the top to fly off of your chosen sector any day now, steer clear.

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About Matt Murphy

I'm a software engineer with a certain company you've probably heard of. In my free time, I'm an advocate for individual liberty and free markets.
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