Bubbles

The market does a good job at valuing shares based on the available information. But, once in every few years, the market behaves in an irrational way.

While the internet bubble was developing, I wrote the following in a post on Motley Fool All UK Shares board on 28/11/99 (I think you may still find it there). The bubble burst a little over a year later causing severe losses to many.

"Charles Kindleberger wrote a history of financial crises under the above title [Manias, Panics, and Crashes]. He thinks that financial manias and panics follow a consistent pattern [my thoughts in brackets]:
1.The upswing starts with an opportunity - new markets, new technologies, etc that promise investors large returns. [This time the massive riches that will be generated by the internet?]
2.This attracts more and more investors resulting in rising prices and people invest everything they have and borrow to invest even more. [The second most hits on the internet are for financial sites. I find the Investors' Chronicle and FT being sold in my local Tesco. New investment magazine titles hit the news stands and TV programmes on investments have become popular.]
3.In the manic phase, investors become desperate to get out of cash and into the sort of assets that they see making other people rich. "... a larger and larger group of people seeks to become rich without a real understanding of the processes involved." [People who have made some quick money following some method in these sort of conditions think that they have "discovered" some infallible method. Some give up their jobs to become full time traders or "investors".]
4.Eventually prices stop going up. The truth dawns that the prices are too high to be justified by fundamentals. People with debt are forced to sell resulting in prices going down. [Prices cannot go up at this rate for long. Expectations will eventually align with reality.]
5.Then the bubble bursts and there is panic. People scramble to unload whatever they have bought at greater and greater losses and cash becomes king. [Those who have borrowed to "invest" have no choice; they have to sell to meet their repayment obligations.]

Nobody can predict the short term trend of the markets. Those who try often turn bearish too early and get very badly squeezed. However, as George Santayana (philosopher) said, those who do not learn the lessons of history are condemned to repeat it."


Most investors would have heard of famous bubbles like the South Sea Bubble. Burton Malkiel, in his classic "A random walk down Wall Street" provides an entertaining account of various bubbles of more recent times:
1 The "tronics" boom when electronics company stocks were the fashion and even some non-electronic companies contrived to have some version of "tronics" in their name to boost their stock prices.
2 The conglomerates boom where the magic word was "synergy".
3 Concept stocks where all that was needed for the price to soar was a good story.
4 The "nifty fifty" or "one-decision" stocks where you buy excellent companies, whatever the price, and hold forever.
5 The new issues craze where companies with names linking them to new fields like microelectronics were in huge demand irrespective of price.
6 The biotechnology boom. In the 1980s some biotech stocks sold at 50 times sales (yes, sales - not profits).
7 The Japanese land and stocks bubble. This became so big that "the Japanese could have bought all all the property in America by selling off metropolitan Tokyo. Just selling the Imperial Palace and its grounds at their appraised value would have raised the cash to buy all of California".
8 The internet bubble. It was though that the internet would revolutionise business. It did, but it did not mean that "investors" who paid ridiculous prices for any company that smacked of the internet would get rich. As in many emerging technologies, it is the consumer who benefits and most of the companies at the forefront of the technologies never make it.

One common theme about all these bubbles is that there were always new theories to justify the high prices and the belief that things were different this time.

Some quotes:

Benoit B Mandelbrot

1. The sub-prime mortgages that undermined our great banks were written on the false assumption that what had been seen before would, more or less, persist into the future: housing prices would keep rising, defaut rates would stay within a forecast range, hedging strategies that worked hitherto would keep on working. That kind of thinking has led to every financial bubble in history...
   

Warren Buffett

1. The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring in pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem though: They are dancing in a room in which the clocks have no hands.
2. What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes [WB was writing about Aesop's "bird in hand is worth two in the bush" earlier in the 2000 letter to shareholders], promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their own friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed to making money off investors rather than for them. ... But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street ... will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.