We have spoken until we have become blue in the face and sick to the stomach about inflation. One of the main characteristics of inflation is that it keeps creating more inflation. As artificial "stimulus" wears off more inflation is necessary to keep the economy from collapsing and this prompts politicians to create more money out of thin air which creates more inflation. The side effect of all this printing is that yes indeed there is more money on the streets. But more money on the street means higher prices. And yet, what we see is not a homogenous (i.e. all equal) inflationary state of affairs. Some goods and services rise in prices far faster than others.
Those unusual goods and services typically do so because they are believed to be either "good investments" or "good deals", thus everybody and their hamsters "invests" in them and in so doing they create Ponzi schemes. Every new sucker must hope they are not the last one before the entire scheme collapses. This process makes investing during inflationary times difficult. These goods and services are described as being in a "bubble". This name is very apt because eventually all bubbles pop and/or deflate (mostly pop).
For inflationary situations there are two money-making strategies. The first one is simple; buy and hold. For how long? Forever. For that you need goods that will produce income all the time, in good and bad times. If you do so then you don't really care too much If (when) the price of the good drops since you will never sell. This the case for good rental real estate (emphasis on good).
The second one is hit-and-run. You enter into the scheme early, you ride the scheme and you get out before it pops. This is the buy-low-sell-high strategy.
Both strategies are difficult to implement because you don't really know which goods are in a bubble or where the bubble may be in terms of growth. Furthermore, it is difficult to ascertain other parameters such as if rental property X will be "rentable" post-bubble and so on. But the first parameter that needs elucidating is whether or not a given good is in a bubble and this is what this article is all about.
IS IT IN A BUBBLE?
In order to find out if something is in a bubble all we need to do is to compare the rising of its price with the raising of the country GDP. That's it! Simple right? Well, yes it is! Although we know that the GDP is deeply flawed (see GDP Keynessians Vodoo Economics) it is still a mildly useful measure. As the GDP is the rosiest picture politicians paint, it thus depicts the best case economic scenario and it includes newly created money. Which means that if something is raising well above it, there are no other reasons for so behaving other than it being in a bubble.
Economic data comes in two flavours:
- Absolute prices
Absolute prices are just that, absolute prices in whichever currency you prefer. Typically you would use the currency of your country of residence. If this is the case, you would plot the normal GDP (not a constant-currency corrected GDP) against the prices of the good you are analyzing.
Indices, on the other hand, are simply prices relative to prices at a specific point in time. Typically in the description of an index it would state something along the lines to "1995 is the 100%" or "relative to 1995" or something like that. Which year it is relative to is not important. If this is the data your good is tracked with, then you must compare it against the "GDP Deflator" which is the same type of index.
GDP data can typically be found in your Central Bank or IMF or World Bank websites. The data for the good you are analyzing can be found elsewhere but more than likely you will find it in the Internet with just a little bit of digital digging. You would be surprised!
OK. You have the data for the GDP and the good you are analyzing. Now what? Now, go to excel and plot both data series on the same plot. You will end up with five "most-probable" scenarios:
- The distance between lines remains more or less the same. Both lines rise at roughly the same speed. If this is the case this means that your good is rising in price along with the GDP. Your good is in inflation but not in a bubble.
- The distance between lines remains more or less the same but both lines drop at roughly the same speed. If this is the case this means that your good is dropping in price along with the GDP. Your good and the GDP are in a severe deflation but not in a bubble.
- Both lines go up but the GDP line rises faster than the "good" line. Your good is in a moderate deflation.
- The good line rises faster than the GDP line. Your good is in a bubble.
- The good line drops faster than the GDP line. Your good is in deflation.
And that's it! Yes, for those mathematically inclined you may de-bias one series and relative it to coincide with the other, interpolate to fill-in missing points and subtract one series from the other and then plot. If you get a flat zero line there is no bubble nor deflation. If you get a positive line you get a bubble and a negative line implies deflation. But why torture people with other complications if visual comparisons work the same?
Is this method bullet-proof? Of course not! The point is that this method provides you with a simple and handy tool to do your research.
Note: please see the Glossary if you are unfamiliar with certain words.