The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

28 October 2008

What goes up must come down

What goes up must come down

For more than 400 years, financial ‘bubbles’ and panics have shaken empires and altered history. It’s happening again with the housing bubble. Why don’t we ever learn?

What is a financial bubble?
Bubbles are a market phenomenon in which something’s value is inflated far beyond its intrinsic worth. They are probably as old as commerce itself, though the first outbreak of market delirium identified as a bubble was the Dutch Tulip Bubble of 1636–37. A few decades later, the British government tottered after hundreds of thousands of Brits went broke investing in a South American real estate boom. In the 1800s, countless Americans lost their shirts speculating on railroad stocks. The 20th century brought the most destructive bubble of all—the credit-fueled stock speculation of the Roaring ’20s that ended in the Great Depression. More recently, the U.S. has been rocked by the Internet bubble of the late 1990s and this decade’s housing bubble, which ushered in today’s worldwide financial crisis. In fact, bursting bubbles led to nearly all 11 recessions the U.S. has suffered since the end of World War II.

Do all these bubbles have anything in common?
They’re all outbreaks of what historian Charles Mackay called “the madness of crowds.” (See below.) Take the tulip bubble. In the early 1600s, a mysterious virus infected many of the Netherlands’ tulip bulbs, which suddenly started producing brightly colored flowers with unusual streaks and whorls. A craze for the flowers developed, and during the winter of 1636, many Dutch started trading promises—futures contracts, essentially—to buy or deliver tulip bulbs the following spring. Prices rose furiously. One eager buyer traded his house for a single bulb; another swapped 12 acres of land. The outlandish prices brought in even more traders seeking easy riches, and initially, prices rose as new buyers surged into the market. But promises to deliver bulbs outnumbered the actual supply, and as spring approached, many people who had contracted to deliver bulbs couldn’t fulfill their obligations. Contracts to buy the bulbs were suddenly worthless, and the market crashed.

People really thought tulips could make them rich?
It sounds silly. But that’s the nature of bubbles—frenzied speculators part with common sense in their “irrational exuberance’’ for the next big thing. In the mid-1800s, new U.S. railroad companies were working to link markets that had never before been connected, thus revolutionizing commerce. Millions of Americans borrowed money to buy shares in railroad companies, and stock prices soared. But the steep costs of building the railroads proved too much for many companies, and several collapsed, ruining investors who planned to repay their loans out of their stock profits. The Internet bubble of our own time was remarkably similar.

In what way?
Investors were so excited about the potential, they lost sight of reality—hope triumphed over reason. Take the notorious case of Webvan, a company that delivered grocery orders placed over the Internet. On the day Webvan went public in 1999, its stock market value soared from $375 million to $8.5 billion—one of the best opening days of any stock in history. Webvan could never deliver enough groceries to justify that value, and the company went bankrupt in 2001. But it wasn’t just faith in the Internet that led speculators to bid up Webvan’s price. They also had faith that other people believed even more fervently in the Internet’s potential. In short, people who paid a foolish price for Webvan and hundreds of other Internet firms figured they could always find a greater fool to pay an even higher price. And many did, compounding their folly by buying their shares with borrowed money. Eventually, of course, the bubble burst.

What does borrowed money have to do with it?
Without borrowed money, there likely would be no bubbles. That’s because bubbles first inflate when credit is easy to obtain, and pop when credit tightens. During the stock bubble of 1929, for instance, many investors bought shares with borrowed funds. When prices started to fall in October 1929, investors rushed for the exits, hoping to sell their shares while they were still worth more than their loans. But because everyone was selling at once, stock prices plummeted, leaving many investors with debts they couldn’t repay. Many U.S. banks were among those investors. Hearing about the banks’ losses, depositors rushed to withdraw their funds, starting a bank run that caused thousands of banks to collapse.

Is something similar happening today?
In many ways, yes. The housing bubble first started to inflate when interest rates fell to 1 percent after the 2000 dot-com crash. Banks happily granted mortgages to almost anyone who could fill out an application. Millions of borrowers bought houses they really could not afford, figuring they could sell at a profit if they got in a pinch. It wasn’t such a far-fetched idea—in much of the U.S., housing prices had risen steadily since the late 1970s. But prices eventually hit a peak and started to fall, and the inevitable stampede for the exits began. As in 1929, says finance professor Lawrence Kryzanowski, people thought “the good times were going to go on forever. And then very quickly, they stopped.” History provides one consolation, however: Just as every boom inevitably comes to an end, so does every recession.

The madness of crowds
Many economists believe that people tend to make rational financial decisions. But the recurrence of bubbles suggests that greed, emotion, and peer pressure can overwhelm rationality. When we see friends and neighbors making big bucks trading dot-com stocks or flipping McMansions, we want in on the action. For a while, as everyone joins the party, rising prices become a self-fulfilling prophecy. But then comes a seemingly minor event that reverses the psychological polarity, turning endless optimism into bottomless panic. (In the case of the housing bubble, it was one big bank’s announcement in March 2007 that it was experiencing higher-than-expected losses on its mortgage holdings.) The same herd mentality that drove people to crowd into the market now drives them to flee the market en masse. Falling prices then become the self-fulfilling prophecy, and the panic feeds on itself, sweeping aside caution, common sense, and historical memory. Super-investor Warren Buffett has seen it happen over and over again through the years. "What we learn from history,” he likes to say, “is that people don’t learn from history."

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