The Four Dynamics of Bubbles

The Four Dynamics of Bubbles by Charles Hugh Smith for Daily Reckoning

Editor’s note: Central banks have inflated bubble after bubble. Today, Daily Reckoning contributor Charles Hugh Smith shows you the three stages of bubbles – with a fourth for good measure. He also addresses how long the show can go on.

Dear Reader,

Financial bubbles manifest three dynamics: The one we’re most familiar with is simple human greed, the desire to exploit a windfall and catch a work-free ride to riches.

The second dynamic gets much less attention. Financial manias arise when there is no other more productive, profitable use for capital. And these periods occur when there is an abundance of credit available to inflate the bubbles.

Humans respond to the incentives the system presents: If dealing illegal drugs can net $20,000 a month compared with $2,000 a month from a regular job, a certain percentage of the workforce is going to deal drugs.

In our current economy, corporations have sunk $2.5 trillion in buying back their own stocks because this generates the highest work-free return. This reflects two realities:

  1. Corporations can’t find any other more productive, profitable use for their capital than buying back their own shares (enriching the managers via stock options and the 10% of American households who own 93% of the stocks).
  2. Thanks to the Federal Reserve and other central banks injecting trillions of dollars of nearly free credit into the financial sector, corporations can borrow billions of dollars to play with at near-zero rates that are historically unprecedented.

So borrow billions at 2.5%, pour it all into buying back your own stock and reap the gains as your stock rises 10%.

Recall the basic mechanism of stock buybacks: By reducing the number of shares outstanding, sales and profits go up on a per share basis — not because the company generated more revenues and profits, but because the number of shares has been reduced by the buybacks.

(Note to New Green Deal advocates: If corporations reckoned they could earn more by investing the $2.5 trillion in alternative energy projects rather than stock buybacks, they would have done so.)

As various sources have outlined, corporate stock buybacks have been the primary driver of higher stock prices.

This is driving the third dynamic of bubbles:

As the bubble continues inflating beyond any rational valuation, rational investors throw in the towel and join the frenzy. Once again, this willingness to abandon rationality is partly fueled by greed and also by a dearth of other more attractive investments.

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