The Bubble Part One

There's been a good bit of talk around TCI lately about whether housing prices are in a bubble or not. My own opinion is that certain markets are in bubbles and others are not. Most notably in California but also some markets in Florida have what appear to me to be the markers of a bubble-- excessive leverage, sales prices that are more or less unrelated to the rental value of the house and "excessive exuberhance".



So I thought I would sit down and write an article on the nature of investment bubbles in general and the ways that real estate bubbles are similar and different. As an introduction to such an article I thought I'd examine Bubbles in general in part because I wanted to get a bigger context for the phenomenon than our current point of view.



In the process of doing my research for such an article I came across this article by Jacob Friefeld which was apparently written for a graduate level class in Behavioral Decision Making. I wrote to Mr. Friefeld asking for his permission to use his paper (written in 1996) as an introduction to my discussion of Real estate bubbles and he has generously consented to its use.



Because this paper is, by itself, longer than the average TCI article. I thought I would submit it in two parts and will, in the next few days follow up with my discussion of whether house prices are in a bubble or not and how you would tell.



Unfortunately TCI's system will not allow us to show the graphics included in the paper. If you wish you may read the article at



http://www.clarity.net/~jake/bubble.htm



Where the stock charts are also visible Almost everyone, in one way or another, makes investments via the financial markets. Whether deciding what stocks to buy themselves, relying on the decisions of an investment manager when purchasing mutual funds, or relying on a company pension plan, most people are financially dependent on decisions made about their investments.



Others, for fun or profit, choose to speculate in the marketplace. This involves making short term, risky bets on the value of one security or another. Investors and speculators have different goals; investors look for long term gains at relatively little risk, and speculators go after large, quick profits while taking large risks.



Investing and speculation are all about decision making. In particular, they are about decision making under uncertainty, and under the alternating emotional pressures of greed and fear. Under most circumstances, the market is dominated by rational investors who are willing to pay reasonable prices for stocks based upon reasonable, feasible expectations for a given company's future. However, periodically throughout the history of free markets, there have been recurring "speculative bubbles" in which the market for a given stock, all stocks, or other assets such as real estate, art and even tulip bulbs is overcome by euphoria and rushes upward, only to collapse a short time later, usually over a time period spanning less than three years. What causes these bubbles? Why do investors suddenly become speculators?



Experiments in virtual trading among humans in a controlled environment also show evidence of speculative bubbles, even when the money is fictional, and the "true" values of securities are given to the participants at the beginning of the experiment. In this case, participants have nothing material to gain from such speculation, and by some arguments should behave in a purely rational manner and buy and sell at or near the given "true" values. Yet experimentally this does not happen, raising the hypothesis that for some reason, an attribute of markets is that at certain points they reach levels that are clearly above the true value of the underlying goods. Why does this happen? This paper will attempt to get into the decision making dynamics of markets that are crowded with investors-turned-speculators who are eager to profit.



The Theory



Throughout history, speculative bubbles have had some common features. There are certain financial preconditions, which invariably include leverage coupled with some other financial "(re)discovery" such as the power of the joint-stock company, the option, or risky debt (junk bonds). In some cases this financial innovation is replaced by changes in government policy that either favor easy credit or lower taxation, stimulating rapid business growth. Whatever the case may be, a financial atmosphere of tremendous supply combined with demand for some desirable asset, be it stocks, real estate, or even rare tulips, gives birth to the speculative bubble.



Participants



There are two types of speculators who participate in the growth of the bubble. The first is the type of person that believes that for some reason, the price of this object of speculation will move tremendously higher, and remain there indefinitely. While this type of expectation clearly adds to the bubble, this alone will not cause the market to rise tremendously. For example, consider a theoretical market consisting of 10 investors and speculators, and one stock. If the stock is currently at $100, and one of the speculators suddenly realizes for some reason that the stock is worth $1000, they will commit all of their capital, driving the price of the stock temporarily higher until they have purchased all that their credit or margin will allow, after which the price will return to $100, or at least cease to climb.



However, the situation changes when the second type of speculator enters the picture. This type of person subscribes to the "greater fool theory" which says that an asset should be purchased as long as there exists at least one "greater fool" to whom that same asset can be sold at a higher price. This theory is also known as the "Castle-in-the-air" method of valuation. This strategy is what throws the market out of balance and fuels the second half of the bubble. These individuals will continue to purchase regardless of market levels, considering only the willingness of other individuals in the market to pay higher prices. At this point the bubble inflates itself, because a growing portion of the market is self-referencing, making decisions while looking inward.



Thus the core phenomenon of the speculative bubble is one in which euphoric levels of valuation are validated by the market, and intelligence is measured only by profits, not reasoning and judgment. This is similar to the "hot hand" maxim in basketball which says that players will predict with great confidence their ability to score again after scoring, despite statistical evidence to the contrary. In much the same way a speculator sitting on an enormous unrealized and increasing profit becomes even more confident in his/her own insight into the tremendous future profit opportunities of the bubble. Although this form of irrational representative thinking cannot be shown to be incorrect as in the "hot hand" case, it is intuitively not necessarily true that there is a direct correlation between intelligence and profits in the financial markets. The phrase "financial genius before the fall" refers to this overconfidence by both the speculator and financial innovator at the peak of the speculative bubble. Near the point at which both classes of people are hailed as brilliant and at which, according to economist Irving Fisher of Yale University "stock prices have reached what looks like a permanently high plateau," the bubble is at the bursting point.



The speculative bubble as a phenomenon of free markets would not continue to resurface time and again were it not for the fact that the financial memory of a given society is very short term. Veterans who have experienced previous bubbles and warn of disaster are quickly ignored by fresh, young generations, eager to realize tremendous wealth through speculation. Even after the debacle of 1929, which led to the worst post-speculation economic depression ever, speculation was back in style a mere forty years later in the form of the "New Era" growth stock craze and the "tronics boom," in which any company with "electronics" or "silicon" in its name was worth three times a comparable, but not so cleverly named company.

Sellers



Who sells during a speculative bubble? During such periods of euphoria it may seem bizarre that anyone would be a seller in the marketplace. However, common sense tells us that without a seller for every buyer, there are no transactions (until the buyers offer to pay a high enough price that there are people willing to sell again). There are three types of sellers during a bubble. The first is simply the speculator unloading shares (or whatever the speculative asset may be) to cash out or to free up money to plunge into other classes of bubble stocks, tulips, or whatever the case may be. The second is selling as part of their normal business of dealing or making a market. Although securities dealers are most visible, there are professional real estate and art dealers, and at one time there were professional tulip dealers. These professionals (if that is the right word) buy and sell frequently and for the short term, keeping the market liquid and earning good, low risk money at the same time. The third type of seller is the "bear," or speculator who is betting against the bubble, borrowing shares and selling them in anticipation of a price decline, with a commitment to purchase and return them at a later date.



Examples of Speculative Bubbles

The Tulip Bubble



There is some record of speculative bubbles dating as far back as the 1300s, but the first that stands out from history took place in Holland from approximately 1620 to 1637. This speculative bubble involved rare, collectible tulips. The tulip, native to the Mediterranean, was first imported to Holland well before 1600. Beautiful tulips gradually became collector's items for wealthy Dutch people. As time progressed, rarer and more valuable classes of tulips emerged. Tulips mutated by botanists and others infected by a virus called "mosaic" (which did not kill the tulip, but instead caused its petals to develop contrasting "flame" patterns) began to sell for incredible prices. Entire homes, horses and carriages were traded for tulip bulbs in some cases.



Further enabling the bubble was the innovative climate of Dutch finance. While futures contracts had been in use for several centuries by this time, Dutch speculators invented a new financial instrument similar to what is known today as the option. The low cost and tremendous leverage of this security broadened the speculative frenzy and allowed all members of Dutch society, including farmers, chimney sweeps and maid-servants to give up their jobs and speculate in tulip bulbs. Land and other assets were pledged for credit with which to purchase tulips, bringing leverage into the picture.



In 1637 the bubble stretched and burst. Credit had been exhausted; bulb dealers were unable to find buyers for their more expensive bulbs, sparking a selling panic. The plunge in tulip bulb prices left many who had purchased on credit bankrupt. Earlier contracts to purchase (such as futures and options) were defaulted upon, and soon a nationwide depression followed. In the end, rare tulips sold for almost nothing, down over 99% from their peak.



The South Sea Company



In England, from 1711 to 1720, the short life of the South Sea Company is almost purely based upon speculation. The financial innovation of the day was the joint-stock company, which we know today as the publicly-traded corporation. Against the backdrop of other absurd joint stock companies (soon to be known as "bubble companies") such as one to produce a machine gun that fired both round and square bullets, Robert Harley, Earl of Oxford founded the South Sea Company. The company was chartered by the English government in return for assuming the country's massive war debts, for which they were paid 6% interest. In addition, the government granted the South Sea Company a permanent monopoly over trade to North and South America. Although the company was unable to ever profit in any way from this franchise (because Spain controlled most of the Americas), the potential that this "monopoly" presented was irresistible. The few English who had profited in the recent wars drove the price of shares to £128 in January of 1720, and soon other British aristocrats succumbed to greed and drove the price higher, peaking at £1000 in July.



Throughout 1720 other "bubble companies" had formed, with ridiculous but attractive business plans such as to "transmute quicksilver into malleable fine metal" and the most infamous, to "carry on an undertaking of great advantage, but nobody to know what it is," which resulted in the one day sale of £2000 worth of shares and the promoter leaving the country that same day. Soon after, the government passed the Bubble Act, outlawing all such scams, except for the South Sea Company. This broke the fever, and the shares in the South Sea Company collapsed, reaching 124 by the end of 1720. Incredibly, the bulk of this speculative bubble happened inside of one year.



The Florida Real Estate Craze



Beginning with Florida real estate, the 1920's saw the greatest period of speculation in American history. Sparked by the favorable climate, farmers who wished to enjoy warm winters while their land lay fallow purchased plots of land in Florida. They were soon followed by successful bankers from New York, eager to vacation and flaunt their wealth at the same time. Then, as is true today, real estate could be purchased on mortgage for only about ten percent down, which provided the financial leverage for the boom. Mania rapidly built, with acres of Florida swampland going for up to a thousand dollars (a lot of money at the time) and dirt being trucked in to make swamps into land to meet the demand of speculators. At the peak, one third of the population of Miami consisted of real estate agents which in hindsight should have been a warning of impending disaster. Among wealthy Americans, a contest of extravagance took place, with everyone trying to own the most palatial estate around.



The Florida real estate bubble was burst prematurely by a sudden hurricane (hardly unknown to the region) which destroyed many homes and caused tremendous property damage. Soon prices collapsed, and the usual bankruptcies and defaults followed not far behind. Florida was quickly forgotten as speculation went national in the stock market boom of 1926-1929.



U.S. Stocks 1929



In the early 1920s the business climate could not have been better. According to the president "the business of America [was] business." The American businessman reached a level of social status usually reserved for accomplished professors or diplomats. Corporate profits, Pro-business government policy and margin rates allowing stock to be purchased for only 10% down pumped the market for U.S. stocks to euphoric heights from 1926 through September of 1929. In what seems to be an occasional feature of speculative bubbles (see the Presstek example below), near the peak there was some debate among prominent economists and bankers about whether the market was headed for boom or bust. Those who predicted a crash were criticized and scorned into silence by rabid speculators caught up in what seemed like a new plateau of stock valuation.



As the limits of demand and capital were tested in September 1929, the market drifted slightly lower, and then the selling built into a deluge. During two October days, more than $9 billion of the market value of American business was erased in a panic that left prices 25% lower. Far more devastating to the country and the entire world was the depression that followed. Stock prices bottomed 90% below their 1929 highs in the aftermath of what is probably the most far-reaching and widely felt speculative bubble in economic history (the tulip mania may have been more worse, but it was focused in Holland).




Mr. Friefeld currently opperates a fund managment company called Southbrook Capital Mgt LLC. Their website is



http://southbrookcapital.com/