Bear rallies emanate from psychological leftovers of bubbles.  When a bubble stays around too long, most begin to view it as the norm.  When the bubble bursts and the pain becomes unbearable, most pine for the “good old days.”  Their collective action causes a rally that creates the illusion that the bubble has returned.  But a bubble, after bursting, can never be brought back.  If you blow air into a balloon with a hole, it can puff up if you blow hard enough but as soon as you stop blowing, it deflates again, to nothing. 

Governments and central banks are trying hard to stop asset prices from falling. The hope now rests on government bailouts.  Interest rates are near zero and budget deficits are at scary levels. When inflation rises, it will close the door on more government bailouts.  When the last hope is gone, asset prices will truly bottom.  I think this will happen in 2010.

Some argue, why can’t we revive the old bubble or start a new one?  The problem is that after a bubble has lasted several years, its bust leaves so much rubbish around that a new bubble cannot take root.  For example, high levels of existing debt make further debt growth difficult.  Without debt, a new bubble would have no legs. The economy needs time to recover before it can support another bubble.  If you are waiting for another bubble to bail you out, I am afraid it’s going to be a long wait.

Human psychology is surprisingly susceptible to a collective change in mood.  Herd mentality is a well recognized but unproven psychological phenomenon.  A person is more likely to believe in something if people he or she knows already do.  The safety-in-numbers behavior is often observed in the animal kingdom.  While crossing the African savanna, migrating wilder beasts cross crocodile infested rivers together. The idea is that the crocodiles can eat only one wilder beast at a time. When many cross at the same time, only one will be eaten, and the rest can cross safely. It seems that many succumb to the herd mentality to handle risk in the financial world. Bubbles appear repeatedly in human history, despite the setbacks they cause, because the herd instinct remains deeply rooted in our brains and takes control when the environment permits.

When wilder beasts cross a river together, the advantage is real.  If they cross separately, they give more time to crocodiles to eat them.  For this advantage to be realized, a herd of wilder beasts needs a leader, someone who begins the rush.  The first one to go has a higher probability to be eaten.  Hence, in this case, irrational behavior, though not advantageous for individuals, is good for the group.  The evolutionary advantage of such irrational behavior for the collective well being is the reason it is so prevalent in the animal, as well as human, world.

Similarly, some bubbles are actually advantageous for economic development.  For example, the IT bubble created and perfected technology that is still benefiting the world today, even though those who invested in it lost their money.  Those who thought IT would make them rich are like the head of the wilder beast herd, unknowingly sacrificing themselves for the common good.  Most technology-driven bubbles are like that: good for the world but bad for investors.  Joseph Schumpeter’s theory of creative destruction is about such bubbles.  Because so many bubbles are not harmful, governments and central banks have taken a cavalier attitude towards it.

From time to time, a huge bubble of productive assets builds up.  In most cases its consequences are devastating.  The global property bubble falls into this category.  Derivative products – another class of unproductive assets – hid leverage behind the property boom and made it bigger than any other in history.  The debt accumulated for building unproductive assets caused widespread bankruptcies (e.g. the U.S. in the 1930s), hyperinflation (e.g. Germany in the 1920s), or massive government debt (e.g. Japan in the 1990s).  It takes a long time, and a productive debt bubble, to heal the wound.

The pain so far is acute but not depression-like.  The reason is government stimulus measures are helping businesses and households stay afloat despite their insolvency.  As governments exhaust their fiscal and monetary firepower, they are trying to verbally improve investor confidence, hoping that asset markets will improve and economies will follow. Such verbal stimulus is indeed having an impact.

For example, the U.S. government is conducting a stress test on the banks.  The test is a scenario analysis, i.e. whether banks can survive the downturn under different possible scenarios. I am sure most banks would ‘pass’ the test with flying colors, but this is self-deception. The U.S. financial system is technically bankrupt. The strength of a banking system reflects the strength of the economy it serves. Just look at the balance sheet of the U.S. household sector. How could U.S. banks survive when so many of their customers have negative equity?

Such confidence tricks are significantly impacting sentiment and financial markets, but they can’t reverse the trend.  Property prices are falling and unemployment rates are rising across the world. Temporary euphoria in financial markets cannot reverse that.  Reality will eventually extinguish the irrational euphoria. Once inflation rises, it will close the final door of hope – the government bailout. Interest rates can and will rise despite badly performing economies. Only then will asset prices truly bottom out.

The false hope today may feel good but it only delays necessary reforms. It actually makes things worse. As governments spend money to revive the past, they won’t be left with money required to ease the pain caused by structural reforms in the future. The world is behaving like a bankrupt drug addict, spending welfare checks to feed an addiction.  Once the checks are all spent, the addict has to go cold turkey to kick the habit.