20 September 2007

Bubble, Bubble, Toil & Trouble: the paradox of financial bubbles

For the average investor or home owner, the bubbles the press loves to warn about are simply noise. Bubbles occur less often than people think simply because there is more demand for good investments than there is supply - a condition that always drives up prices. Perhaps the simplest bit of evidence that demand outstrips supply is this: there are now more mutual funds and index funds than there are stocks listed on various exchanges.

How is a person to tell the difference between high prices and a bubble? At one point, stocks are simply pricey by historical standards. At another point, said stocks are outrageously priced, a sure sign of a deluded populace.

Of course, such a distinction is hard - if not impossible - to call in advance. I live in a County where the median house price topped half a million recently. Sure sign of a bubble? San Diego is blessed with gorgeous weather, the climate of an indoor shopping mall, and all the accouterments of a big city (well, not New York or Paris style accouterments). Houses are getting larger. Each year, only about 2% of the houses sell - meaning that market prices are set by an elite few - not by the average Joe. One could probably point to as many reasons why $500k was justified as reasons why it was evidence of madness.

The bubble that set the bar for all subsequent bubbles was the Dutch tulip mania in the 17th century. At the peak, tulips sold for hundreds of times what an average man made in a year. (Put in perspective, a 100X multiple of the average American working man's wage would set the price of tulips at $40 million a bulb - probably the kind of item that Home Depot would keep behind the counter.)

It's easier to expand the number of tulips than the number of homes or profitable companies in which one can buy stocks. In this sense, the Dutch tulip mania is probably misleading. Tulips reached a price they've never attained since - as contrasted with stock prices that "peaked" in 1929 and are now more than 30X what they were at that peak.

Bubbles make for good press. As a country, we are still squeamish about returns to capital. Not "working" for one's money seems unnatural. And yet investments do generally rise in value, as much as we like to wring our hands as markets reach all time highs. (Even this is misleading: if you put money in a bank account that paid only 2% a year, your account would reach an "all time high" at the end of every month.) In any case, demand for evidence that our neighbors are mad is always steady: demand for stories about a financial bubble feeds a small industry.

It's true that prices for even homes and stocks can rise too high. But bubbles seem to invariably follow from an increase in quantity demanded - an increase of money "demanding" investments that provide a return. Little commented on is what a huge amount of money is in search of returns nowadays - trillions and trillions all bidding up the prices of stocks, real estate, gold, bonds, fine art and crude oil.

The Dutch tulip mania reached its frenzied peak only decades after Dutch investors were introduced to the Dutch East India Company. Even by today's standards, the Dutch East India Company was a remarkable investment, paying an 18% annual dividend for two centuries. Such returns on such a scale were unprecedented and laid the foundation for capitalism - international bond markets, stock markets, and Central Banks as we know them were just a few of the more impressive consequences of this early investment miracle. But what to do with the 18% dividend payment? Where to invest it? The supply of good investments was spotty. The result? People bid up the price of even very questionable investments such as tulips.

Why did stock prices rise in the late 1990s? Why did home prices go up in the early double-oughts? For the same reason. Financial markets are more adept at providing money for investments than entrepreneurs and companies are at providing sound investment opportunities for such money. The demand for good investments periodically outstrips the supply of such investments. The result? Prices rise. (And I'd argue that this will continue to happen with even greater frequency.)

Is it a bubble when the prices rebound to the bubble level within three to ten years? Or is the market simply getting ahead of itself?

The real lesson is that it’s a seller's market. It's worth noting that the majority of the richest Americans didn't get that way from savvy investments. They got that way because they created a great investment - a successful company, typically. (Or had the good sense to be born to someone who did.)

Investment prices will rise and fall more than we'd predict in a linear world, but unless a person can neatly time such rise and falls (something at least as tricky as dancing with an epileptic) these perturbations can only be treated as noise - static you put up with while trying to listen to the radio.

It's probable that home prices in San Diego will continue to fall this year and next. By contrast, it's certain that median home prices will someday top $1 million. If you are in these markets for the long haul, scary price drops in home or stock markets should be treated for what they are - temporary discounts.

We're fascinated by bubbles - whether in fearful anticipation or living in their aftermath. And this is the paradox of bubbles: if we are certain that they can't happen, they will; if we are certain that they can happen, they won't. Lesson? Don't fear bubbles but make sure that the people around you do.


cce said...

Phewww, I'm exhausted by that. Glad someone has a head on their shoulders and can parse the crazy sub-prime market fallout/impending recession 'noise' that's out-blasting all else right now.
I think there's cause for worry with the real estate thing. Americans have been heavily investing in real estate for a few years now, to the exclusion of all else. Now a bunch of us face the fact that we bought high, gambled that real estate would continue to pay off and saved very little. Oops.

Ron Davison said...

Thanks for your patience. If I'd had more time, I'd have made this posting more succinct.
I do know that my default is optimism - something I often use reason to justify.

ThomasLB said...

I guess just like we have stars (Paris Hilton) who are famous for being famous, we also have stocks that are worth a lot of money because they're worth a lot of money.

Jami said...

It's a rule of thumb (not a hard and fast one, though) for large investment advisers that when the public at large starts to get on board with an investment trend it's time for the big boys to sell out and move on. When a couple of professional sports teams are on the field, all the people down there know what's going on and things are pretty much under control. But if you empty the stadium onto the field, chaos results.

Ron Davison said...

I think that there is something to that, but part of it is a simple, "where else are you going to go?" We buy some of the same stocks because the choices are limited.

brilliant little example of the game becoming obscured when the stands empty out. Nonetheless, I tend to side with "The Wisdom of Crowds." I'm a populist at heart and think that for all our foibles, we masses generally do better than the elite few.