The Bubble Part Two

This continues Jacob Freifeld's paper on the nature and history of investment bubbles. As I mentioned in the introduction to Part One my intention is to follow this with a discussion of bubbles in the current real estate enviornment.



This paper is available at http://www.clarity.net/~jake/bubble.htm

where the stock charts which were part of this section of the paper are visible.


'Tronics



After 1960 the disaster of 1929-1934 seemed to be fading from the collective social memory, and once again market players began to compete with each other in search of maximum returns. The mutual fund was all-powerful, as it is today. "Go Go" fund managers outgunned each other with successively more aggressive investment strategies. Technology (or what sounded like it) was the favorite impulse purchase of the day. By 1961 it became clear that concepts or even just words relating to "electronics" or "silicon" multiplied the market value of a company.



The name was the game. There were a host of "trons" such as Astron, Dutron, Vulcatron, and Transitron, and a number of "onics" such as Circuitronics, Supronics, Videotronics, and several Electrosonics companies. Leaving nothing to chance, one group put together the winning combination Powertron Ultrasonics. The prices commanded in the market by these companies was unbelievable.



Hardly a year later, in 1962, the bubble burst. The market declined slowly throughout the early part of the year, and by the end of May it cracked downward. Not surprisingly, the "tronics" stocks and other growth stocks took the lion's share of the beating. Boonton Electronics, for example, declined to $1.62 from it's 1961 high of $24.5.



1987



For the stock market, the years 1984-1987 were strikingly similar to 1926-1929, yet few noticed until after the fact, and then history did not repeat itself, throwing even more people for a loop. The boom was built on leverage and loose government economic policy, just the way it was in the '20s. There were some new "innovations," which in some ways were hardly innovative. Junk bonds, the debt of less creditworthy companies, were found to be exceedingly useful in purchasing companies from their shareholders. In speculative, self-referencing style, this strategy was wise as long as the stock market continued to rise and the companies could be taken public again later for more money. Other financial innovations included program trading and stock index futures, both of which increased the speed and leverage with which investing and speculation could be accomplished.



The fever peaked in October of 1987 and the stock market fell 20% in a single day. Suddenly, fears of 1929 reawakened in the American population, and many expected a heavy recessionary hangover. Incredibly, partly due to the fact that the government stepped in 5 years earlier than they did following the crash of 1929 (the Federal Reserve announced that they would guarantee the credit of market makers the day after the 1987 stock market crash), the recession never came. As fortunate as this may seem, it sets the stage for the next two speculative bubbles, and it could mean that the hangover is still to come.



Presstek and Centennial Technologies





Continuing in chronological order, a recent outgrowth of the 1994 to 1996 boom in technology stocks was the bubble in the shares of Presstek, a developer and marketer of digital imaging technology. Not a terribly hot industry, especially when compared to the booming internet hardware and software business and when considering Xerox and Kodak, the competitors that Presstek faces. However, under the promotion of Carlton Lutz, editor of the Cabot Market Letter, a newsletter which follows rising growth stocks, the price of Presstek stock soared from $40 to nearly $200 in less than a year. In a miniature repeat of "tulip mania," many investors convinced themselves that this was the "stock of the decade" and that it could never turn back. The most interesting wrinkle in this example is that unlike the great speculative bubbles of the past, the arguments, differences of opinion and changing expectations for Presstek are recorded in various internet discussions, in which the reader can match the discussion to the dates on the graph of the stock's price history, hearing the mania directly from the speculators while the stock is on the way up and listening to them groan after the stock collapsed 60% in a matter of two weeks. The discussion is publicly viewable on the World Wide Web at http://www.exchange2000.com/~wsapi/investor/subject-2838.



Although one can almost close the books on the Presstek bubble, Carlton Lutz and the Cabot Market Letter have not been idle. It seems that Centennial Technologies is the next "stock of the decade." The company makes plug-in cards for laptops and PCs, a business that is just as much a commodity business as Presstek's. But hope and greed spring eternal. It is still early on, and the stock is roaring higher day by day. Caveat Emptor.



1997?



Currently the U.S. stock markets are in the late stages of what looks like a speculative bubble. The bubble is as difficult to recognize before it's over as it is easy to spot in hindsight. However, there are some telltale signs that the market for stocks has gone a bit too far. The market averages returned 33% in 1995, and 22% year-to-date in 1996, both numbers far above the 100-year average of 10% per annum. With the most recent frightening recession and associated market decline having ended more than 15 years ago, it is little wonder that many young, inexperienced investors are shoveling their savings into high-performance mutual funds. Once the reality of investment losses slips into history, it quickly passes from the collective financial memory. The current climate for American business is exceptionally comfortable, with inflation remaining dormant and corporate profits growing rapidly. The necessary "financial innovation" of the current boom is the belief that the government can keep this sunny business climate around forever, and that the mutual fund is a sacred investment vehicle. Should any of the inflation or growth numbers (or even public opinion) change unexpectedly, the 1994 to 1997 bubble in American stocks could be the next example written into the history books.



The Theory vs. The Examples



Throughout each of the above examples there are common features. Leverage and other financial innovations or "permanent advances" played a part in every speculative bubble. In every bubble the excess capital, optimism, hope and greed is blown off in a speculative frenzy, only to return again after years of economic contraction or tight credit.



At the core of the speculative phenomenon is the individual, swept up in the euphoria of the crowd, attributing intelligence to those who make profits or becoming overconfident in their own judgment when they begin to profit from speculation.

Conclusion



What conclusions can be drawn from the these theories and examples? Clearly, the speculative bubble is as much an error of decision making and judgment as confusion of the inverse, hindsight bias, or the gambler's fallacy. In fact, hindsight, probability and gambling are integral parts of the speculative bubble. What makes the bubble more complicated, however, is the fact that it is a social phenomenon. As pointed out in the earlier discussion of the different speculative heuristics (or types of speculators), one person who believes an asset is tremendously undervalued will not cause a bubble, but rather a temporary up tick in prices. It is the group, the crowd that gives birth to a speculative bubble. This makes the task of improving judgment more difficult. It requires the individual to break away from the crowd and think logically about history, value and probability. Hopefully, examples from history such as those above will help people to begin to do just that, lessening the magnitude of speculative bubbles in the future. This raises the question of whether cycles of speculative bubbles are healthy or harmful, which is beyond the scope of this discussion.

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



http://southbrookcapital.com/