Financial Bubbles (Part I)
Bubbles, the final economic frontier. This is the voyage of the Market. Its multi-year mission is to explore strange new manias; to seek out new players and new sources of credit; to boldly go where no Market has gone before. (Star Trek music playing in the background).
While a “bubble” is not as vast as the space explored by the starship Enterprise, it can trap many unsuspecting investors within its boundaries. A bubble, for the purposes of this article, is a speculative mania directed towards investment deemed important. The investment can be anything from vehicles traditionally considered investments (stocks, bonds, real estate) to something organic like a flower. Yes, you read that correctly, a flower!
A characteristic of a bubble is the public’s valuation of investments at levels previously unimaginable. The valuations reach unimaginable levels when the implied value of the investment is greatly distant from its intrinsic value. The public may not realize a bubble exists since rationalizations of the implied value are always abundant. For those realizing the existence of a bubble, the investment quickly becomes a hot potato.When there are enough hot potatoes, the mania’s peak arrives and the crash begins.
For example, suppose a company produces bobble head dolls of St. Louis Cardinal pitcher Michael Wacha. The company produces them for $2.00 and sells them for $4.00. The company calls these dolls “Wacha Bears”. Initially, the dolls are available at local retail outlets and sales are commensurate for what you might expect a player of Mr. Wacha's ilk to command. To spur sales of the Wacha Bears, the Cardinals have a Wacha Bear bobble head night at Busch Stadium. The team distributes twenty-five thousand dolls on a warm summer night and children comment to their parents how cute the bobble head dolls look with the bear caricature of Mr. Wacha's face. The retail price of the doll remains at $4.00.
Then something interesting happens. Mr. Wacha creates a Twitter and Facebook page for the Wacha Bear. Soon, children and teens are flocking to Facebook and Twitter for daily updates on the Bear. Cell phone text traffic experiences a pronounced increase on updates to both social networking sites. The company producing the Wacha Bears experiences increases in demand for its product.Understanding economics, the company doubles the price of the doll.
A Cardinal broadcast appears on the ESPN Sunday night game with Mr. Wacha pitching and the announcers mention the sudden Wacha Bear doll craze. The game receives international attention and now orders for the dolls come from overseas. Enterprising youngsters, who earlier bought extra dolls, auction their supply on eBay. Miraculously, dolls are fetching as much as $20.
The producing company’s marketing department develops a limited edition Wacha Bear. The limited edition version sells in stores for $50.Soon, these models appear in eBay with auction sales of $100 commonplace. All the while, Mr. Wacha's successes on the field multiply. He challenges Orel Hershiser’s record for consecutive scoreless innings. This feat receives even more national and international attention. Sir Richard Branson decides he wants to take a few Wacha Bears in orbit around our planet. When returning from his space adventure, Sir Richard auctions these Bears for a record $1,000 each with the proceeds going to charity.
As luck would have it, Mr. Wacha did not break the pitching record, hurt his arm and did not recover from ligament transplantation surgery. The Cardinals replaced him in the rotation with another promising youngster.Without the constant media exposure, interest in the Wacha Bear waned.Parents began to openly question the price of the doll. eBay auctions were no longer lucrative. The St. Louis teen community, which had so thoroughly embraced the Bears, focused on the next edition of Call of Duty Black Ops.From a peak of $1,000, the Bear now sat unsold on retail shelves until its production ceased.Those who had bought Wacha Bears for “investment” purposes tried in vain to dump them. Eventually, a Chinese distributor offered $0.50 for each Bear.
While the previous example dramatizes speculative bubbles, such manias are a part of investment history. The first recorded speculative bubble was the Tulip mania in Holland beginning in November of 1636 and ending in May of 1637 (the flower reference from earlier). During this time, the peak price of a tulip was 20 times that at the beginning of the mania. The mania reached its peak in February of 1637 and fell to its original starting point a mere three months later. Perhaps more importantly, at its peak, the price of a tulip was 10 times the yearly wage of a skilled craftsman.
Manias occur due to the innate human instinct of herding. The investment public tends to act as followers. Manias, or extreme bull markets, climb a “wall of worry.” We use this term since people are afraid of being left out of what they perceive is broad participation (everyone is doing it so it must be good). The rationality of the herding impulse is ignored during the bubble. Few recognize they are in a bubble which is why so many are caught in it.
It takes keen discipline, or a detached investment analysis to understand bubbles. Alternately, you could implant Mr. Spock’s Vulcan brain as your own and understand that most speculative bubbles are “illogical."
Disclosure: None.