Castles in the Clouds – Understanding Market Bubbles


The United States government is currently in a bubble.  With  $16 T in debt and spending outstripping revenues by a trillion dollars or more each year, it has all of the makings of a classic bubble as we saw with housing in 2003-2008 and stocks in 1995-2000.  Today I thought I’d discuss the psychology and characteristics of a bubble.  In the next post I’ll discuss how the US Government is in a bubble and what the ramifications may be when that bubble bursts.

All substantial bubbles include the following:

1.  Credit

2.  Public blindness to market forces

3.  Escalating prices

Bubbles can be thought of as the building of “castles in the clouds.”  Creation of something that is perceived to be very valuable but for which there is no foundation, and therefore cannot last.  Often when a bubble pops and the castle comes falling down to earth there is a great sense of loss, or even a feeling of unfairness, but the truth is the perceived value was never actually there to begin with.  It was a false economy built on credit and not on work or resources.

Think of someone who builds a house on a cliff near the sea in California.  That house may sit on that cliff for years, and the residents may love the commanding views of the ocean and the sound of the waves crashing.  The cliffs are just sand, however, and eventually the ocean will rise during a storm, or torrential rains will wear away at the cliffs, causing the foundation to drop out from under the home, and the home will be gone forever and can never be rebuilt.  Often in that situation the homeowner will eye his neighbors’ homes across the road that now sits on the edge of the cliff and say he deserves that home since the edge of the cliff is his property.  The fact is, however, that his property was never on firm ground to begin with and will never return.

During the dot com boom of the 1990’s, companies that had no profits or even a business plan were having Initial Public Offerings (IPOs) where there share price would double or triple the first day.  Early employees who held company stock became paper millionaires over night.  They began to buy houses and take expensive vacations, often on money borrowed against their stock holdings which were locked up restrictions from the IPO for several months, preventing them from selling.  At one point Priceline, which sold excess seats on airlines, was worth more that the top three airlines combined.  Pets.com, whose mascot was a sock puppet, bought several ads at the Superbowl using cash from it’s IPO.  Perhaps the most amazing feat of all was AOL, whose shareholders were able to convert their fluffy shares to real cash when the company was acquired by Time Warner.  Time Warner soon regretted the purchase.

In this case only a few shares were available to trade – most shares were locked up by insiders.  Because of this, the few shares that did trade were bid up to astronomical heights.  People who had large numbers of shares simply multiplied the shares they held by the current price and thought they were millionaires and billionaires.  No one stopped to consider what would happen if the insiders actually tried to sell their shares, placing far more shares on the market.  As the required holding periods after the IPOs expired and insiders started to dump their shares on the markets, the true value of the companies was revealed.  For many companies, this value was zero.

In this case the credit was actually in the form of locked-up shares.  This caused the perceived value of the companies to far exceed the actual value.  People multiplied their million-share holdings by the current market price and believe that to be the value of their holdings.  Blindness to the economic fundamentals was pandemic, with even seasoned market analysts declaring that “the old valuations don’t matter anymore.”  Price escalations were commonplace, with hot new internet stocks routinely doubling in price every few weeks or even days.

A more recent bubble was the one in real estate.  This one actually traces its roots back to the Fair Housing act of the 1970’s that required lenders to make a certain portion of their loans to low-income borrowers.  Congress directed Freddie Mac and Fannie Mae to buy a certain percentage of these risky loans, which in turn meant the banks and loan agencies had large amount of cash they could only use to make these loans.

Banks and loan agencies thought they were insulated from losses since they bundled the loans together and sold them off, taking the loans off of their books.  Investors thought they could not lose money because they were investing in real estate, which never declined in price very much.  Home buyers saw prices increasing rapidly and began to bid up the prices, believing that they could easily flip the property in a few years for a large profit.

Borrowers, unable to afford a traditional 20% down-payment on loans, began using second mortgages to reduce the amount down to 5% or less.  Eventually, unable to pay the payments for a traditional loan, borrowers began taking out interest-only loans or even option-ARMs in which they actually paid less than the interest charged during the first year or two.  All of this leverage created an illusion of wealth that did not exist, which people used to take vacations, eat out, and buy things.  This created all sorts of jobs creating goods and services for people who did not have the money to pay for them.

In the investment banks where these bundles of mortgages were being purchased, a new insurance instrument called a Collateralized Debt Obligation, or CDO, was created to protect them from losses.  These option contracts allowed the investment bank to collect money from a second party if the value of the loan bundles they purchased dropped below a specified value.  The issue was that the second party didn’t have the money to actually insure the bundles.  Instead, they used some of the proceeds from the CDO’s they sold to buy offsetting CDO’s from other firms.  When the market collapsed, like a circular firing squad no one had the funds available to pay on the insurance policies they issued because they could not collect on the policies they purchased.

After this bubble burst, all of the businesses that were built and expanded during the boom collapsed because they were built on borrowed money rather than on money earned through labor.  Just as with the house on the edge of the cliff, there was never really anything of substance underneath to support them.  Still, the people running and working at those businesses felt a large sense of loss.  Like the homeowner on the cliff, however, the foundation for the business they built was never really there.

There is nothing wrong with making some money from bubbles while they are here, but it is always important to look around at your investments and even your business or employment and ask yourself if it has a sound foundation.  If it does not, be ready to move out when the sand beneath falls away.  And don’t leave anything too valuable inside.

 

Contact me at vtsioriginal@yahoo.com, or leave a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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