Look at “Bubble 1.0” (as it’s known in the relatively young tech industry: the 1997-2000 tech-media-telecom bubble and the general IPO / equity bubble that went along with it).
1. A real change occurred — the uptake of Internet technology — and created some initial successes (think Netscape IPO). This got folks thinking about how to turn a profit, lighting aflame the animal spirits, and buoyed the mood of the markets.
2. Accommodative monetary policy made money cheap, and in combination with the buoyant mood and the animal spirits, led to compressed risk premia in the capital markets. Think insatiable demand for IPOs, and Fed rate-slashing due to LTCM in 1998.
3. Sensing opportunity (and driven to madness by their proximity to money with no ability to make it themselves), those in charge of telling the truth, like auditors, started fudging things in order to keep the good times rolling and to get a slice o’ Cheddar for themselves. Think Arthur Andersen and Enron.
Now, let’s take a look at Housing in 2002-2007.
1. A real change occurred. Think a palpable change in national mood and priorities post-bubble and post-9/11. In the realm of personal finance, we saw an aversion to “paper” assets and a move toward the real and tangible. To many people, this meant plowing what was left from equities into real estate, which had already been enjoying decent returns from the wealth effect of Bubble 1.0.
2. Accommodative credit. Think not only macro level, Fed funds rate stuff, but no-doc loans, NINJA (no income, no job or assets) loans, ARMs, option ARMs, interest-only loans, etc.
3. The truth-tellers started lying. Think the house appraisers here who were being incentivized to keep the party going at risk of losing business from the real estate agents, and the mortgage “officers” who were effectively the “buyer apraisers,” incentivized to keep the party going directly due to fee structures. Nobody in either group called foul on the prices or the creditworthiness in question.
This formula works pretty good, although it’s loose enough that its predictive power is probably fairly weak (better for validating a thesis than for scouting out a new bubble in progress). Any other ideas as to bubbles where we can look for these factors?