“A person is smart. People are dumb, panicky dangerous animals and you know it. Fifteen hundred years ago everybody knew the Earth was the center of the universe. Five hundred years ago, everybody knew the Earth was flat, and fifteen minutes ago, you knew that humans were alone on this planet. Imagine what you’ll know tomorrow.”
— Kay, Men in Black (1997)
The stock market, like a haberdashery, has fads and fashions. Taken to extreme, people find it normal to wear codpieces, sport mullets, or pay $182 billion for America Online (AOL).
When prices rise to irrational levels and then fall rapidly, it is called a bubble. The frequency of these bubble-and-bust cycles has accelerated over the past 20 years.
In a minute I’ll tell you why and how you can profit from it.
The Classics
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| The famed Semper Augustus |
The historical example of a bubble was the Dutch tulip bulb mania in the 1600s.
At the peak, a single bulb would sell for more than 10 times the annual salary of a skilled craftsman. According to the 1842 book Extraordinary Popular Delusions and the Madness of Crowds, at one point, 12 acres of land were offered for a single Semper Augustus bulb.
This first historic mania had several factors recognizable in some of our more recent bubbles, like the housing or dot-com bubbles.
Tulips were a new thing, and they were imported from Turkey, thus making them an exotic story stock, if you will.
Due to a virus, new bulbs produced not just a single color but unique patterns that were highly sought after as a symbol of wealth and power. The downside of these unique flowers was that they took longer to reproduce and died easier.
This means they had scarcity. Demand across Europe climbed.
They also had unlimited future potential. More bulbs could be grown for more profits the following year. This is the same psychology that you find in biotech stocks without earnings that trade at extreme valuations today — or did last year, at any rate.
Futures Market
In 1936, the Dutch created a futures market where contracts to buy bulbs at the end of the season were traded. Traders met at “colleges” at taverns and paid a “wine fee” of 2.5% per trade. No actual bulbs traded hands, but the contracts could trade 10 times a day. People who had never seen a bulb made and lost fortunes overnight.
During the winter of 1636, the price of tulip bulbs skyrocketed… and then collapsed to the point where there were no recorded bids between February and May.
Fortunes were lost. Suicides spiked. Marriages broke up.
History tells us that the reason for the bust is due to an outbreak of bubonic plague in Haarlem. One day, fearing to congregate during a contagion, no one showed up for a routine bulb auction. Almost as soon as it started, it was over. Despite attempts at price support, there were no bids.
There was, however, a bailout of sorts. The courts agreed that all contracts could be settled at 3.5 cents on the dollar — or guilders, as the case may be.
There have been many other bubbles over the years, from Florida real estate in the 1920s to gold in the 1970s and Beanie Babies in the 1990s.
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Bubble Psychology
A bubble by definition is a run-up in asset price followed by the pop when the prices fall. Though many people warn of a bubble when it is happening, they are only certified in retrospect.
There are four basic phases of a bubble:
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Stealth: Investors feel that buying a stock will lead to a higher level of satisfaction versus other spending options.
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Awareness: Investors grow over-confident in their choices. They think about positive results and ignore long-term information. “Hey, my house is up 30% in two years. Maybe I’ll buy a car or put in a kitchen.”
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Mania: More investors come in on the bottom and adopt the same view as the early guys. “Real estate only goes up. They aren’t making any more land” is what you hear at the neighborhood potluck. In order to have a bubble, you have to have great enthusiasm for a given asset. The groupthink and peer pressure makes members feel invulnerable. They rationalize their behavior in the face of contradictory information. And because people are dumb, they make worse decisions as a group.
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Blow off: In the final act, all is revealed. The greedy get what’s coming to them. Prices drop, and reality sets in. No one wants to talk about it. They are in denial on their way to despair. This is, of course, the time to buy. When people say buy fear and sell greed, this is what they mean.
New Bubble
If it were 1994, I would agree with the above classic view of bubbles. That’s how they write them up in the textbooks.
However, in the modern age, very little is left to the free market. We now live in a centralized economy. For the past 20 years, all bubbles have been created by the Fed’s easy money policy. That is why right now we have bubbles in equities, real estate, and bonds at the same time. And no one is particularly enthusiastic about it.
In the next installment, I’ll tell you why today’s bubble is different and how to protect yourself from its inevitable destruction.
All the best,
Christian DeHaemer
Check us out on YouTube!Christian is the founder of Bull and Bust Report and an editor at Energy and Capital. For more on Christian, see his editor’s page.
