Dear Clients and Friends,
Willie Wonka had lots of cool creations, His ‘Fizzy Lifting Drink’ being one of my favorites. Wonka devised a drink that once ingested would create lots of bubbles in the stomach, which then allowed the drinker to levitate. The only problem with this amazing concoction was the harm that it ultimately posed when the consumer levitated uncontrollably into something dangerous, like large commercial ceiling fan. Wonka’s Fizzy Lifting drink is a timely analogy explaining how bubbles form and how they end. Over the last few years there have been numerous articles written about ‘market bubbles’, and I have taken note of many of these bubble theories. From time to time asset price bubbles can form in markets, and this will be the primary discussion on this writing.
Tulipomania is widely considered the first asset-price bubble and has been used as a common case study in asset bubbles. In short, the Dutch created a thriving tulip bulb market and by the mid-1630s, the prices of tulip bulbs rivaled the prices of luxury homes. In 1637 the market for Tulip bulbs went down 99%, effectively bringing the asset bubble to its end. In hindsight, asset bubbles look obvious, but hindsight is often lacking the context necessary to understand the speculative craze that grips the public. Isaac Newton once commented about the South Sea Bubble where he had lost a significant amount of money stating, “I can calculate the motion of heavenly bodies, but not the madness of people”. The Dot Com era is an example that I think most can understand because we lived through it and saw the buildup and bust, real time. Asset prices go up and up and up, and the casual observer can’t deny that people are making money and taking on no perceivable risks. Prices then plummet and we pick up the pieces and rebuild.
In the last few years I have read about a real estate bubbles, Student loan bubbles, a stock market bubble, a bond bubble etc. I have received questions on each one of these bubbles from different people and I have answered them with the same skepticism shown when someone tells me markets are perfect. There are risks in each one of these markets, that is not debatable, but a bubble is a term that needs proper context. Bubbles are typically created when something of worth has its value levitate to prices that are completely divorced from reality. In the case of Tulips, being worth Luxury homes in Amsterdam, the reality that Tulips had very limited economic value when compared to a home became obvious after the crash. However, during the euphoria most buyers only wanted to make money on selling the asset at a profit. Bubbles are simply created by illogical speculative behavior, and those are the signs we need to look for when searching for the bubbles today.
There is one recent example of asset priced euphoria, namely crypto currencies (e.g. bitcoin), but on the whole asset prices in general have been optimistic but rational. Many will argue that crypto currencies are not bubbles because they have value and can be used as a currency. To this I argue that Cisco and Microsoft also had value and great futures, but their stocks lost 70% of their value because the price became divorced from reality due to rampant speculation in the late ‘90s. One finds it very difficult to put a price and a value on something that has limited utility. When you see the price of any asset go up in a parabolic fashion you must look closely at the fundamentals, but ultimately fundamentals create the value in the long run. As investors, if we focus on the price movement, we may be right for a while, and it is going to feel great when asset prices move in one direction. But make no mistake, trees don’t grow to the sky and markets ultimately come back the harsh reality of fundamentals. So, when Wonka admonished his visitors to not drink the Fizzy Lifting Drink, he did so with the knowledge of all the risks that bubbles can create.
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