The Social Good of Bubbles – Part I

Written by Tiffanie Bederman (LinkedIn profile)

Dot Com Stocks. Tulips. Beanie Babies. Railway Mania.

Cryptocurrencies. Canadian Cannabis Stocks*. Credit. Stocks.

Did the bubble just pop? Where are we going (and who’s driving this bus)? The word “bubble” gets thrown around a lot but not a lot of people have a good, working definition of what exactly a bubble is. A sound investment thesis requires a rational framework for valuing the asset in question, a timeframe for the reconciliation of the difference between price and value if any, and a sound understanding of the economic ecosystem that produces different types of price action.

So let’s explore bubbles.

What is a bubble?

“An economic bubble or asset bubble… is trade in an asset at a price or price range that strongly exceeds the asset’s intrinsic value. It could also be described as a situation in which asset prices appear to be based on implausible or inconsistent views about the future.”

Wikipedia – Economic Bubble

“A speculative bubble [is] a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases, and bringing in a larger and larger class of investors who, despite doubts about the real value of an investment, are drawn to it partly by envy of others’ successes and partly through a gamblers’ excitement.”

– Robert Shiller, Irrational Exuberance

Combining these two definitions, we can think of a “bubble” as a period of time in markets when price significantly exceeds intrinsic value for reasons driven by cultural dynamics and/or emotions.

Price vs. Value: Going back to Finance 101, intrinsic value is the sum of the present value of all future cash flows. For securities like bonds, this is straightforward – take the present value of all of the coupons, add the present value of the principal to be paid back at maturity to get the expected current price of the bond. A similar calculation can be applied to dividend-paying stocks by calculating the present value of expected dividends, but one in six companies currently in the S&p 500 don’t actually pay a dividend (you didn’t think this was all about Bitcoin, did you?). These are companies like Google, Amazon, and Facebook (with market caps of $750B, $580B, and $530B respectively) so investors presumably think they’ll gain some sort of value in the future by owning shares.** There exists a grey area in estimating these future cash flows – this grey area is what creates a market. Some participants estimate that the price of the asset will go up, others estimate it will go down – otherwise no trading would occur. An even grayer area exists when the fundamental nature of the contract changes, as occurred in some of the bubbles listed below.

Psychology: Economics assumes that all market participants act in a way to maximize their individual utility. For better or for worse, reality is far messier. A discussion of the underlying reasons behind bubbles is outside of the scope of this article, but some interesting areas for further study include crowd psychology, mass hysteria, and the greater fool theory. As Peter M. Garber points out in Famous First Bubbles, “[p]sychological state of mind is not a measurable concept, especially years after an event. It does, however, provide a convenient way of explaining some phenomena in the market that cannot otherwise be explained” (p.4).

When the financial media talks about bubbles, they are usually using the term to imply an impending collapse in price as well. This can be a collapse in an individual entity, an industry, or an entire economy. More on this in the next post.

Famous Bubbles

Tulip Mania

Description
Tulips, a luxury item, were traded in futures transactions conducted mainly at taverns. After speculators suffered losses in 1636, government officials change the contracts to benefit buyers. Some academics argue this was not a bubble.
Era/Economic Environment
Dutch Golden Age, Middle of the Thirty Years War
Peak Early 1637
Where Netherlands
Ground Zero Speculators
Widest scope
Wealthy merchants and craftsmen
Enabling Financial Condition(s)
The conversion of all futures contracts to options contracts in late 1636
Trigger (if any)
Buyers did not show to a routine auction
Result/Aftermath
no critical influence on the prosperity of the Dutch Republic

 

South Sea Company

Description
A scandalous, kleptocratic scheme devised by Tory leader Robert Harley to reduce British national debt.
Era/Economic Environment
“a time of prosperity and opulence”; end of the War of the Spanish Succession; heavy IPO issuance across Europe
Peak Aug 1720
Where Great Britain
Ground Zero Politicians
Widest scope
Unknown – presumably limited to speculators/investors who had access to London’s stock trading activities (mostly held at Jonathan’s Coffee-House at the time)
Enabling Financial Condition(s)
Rumor mongering, bribery, national pride, New World trade excitement, subscription share model of purchasing stock (leverage)
Trigger (if any)
SSC management selling shares, a decline in all stocks in London and internationally, first payment date for shares purchased on installment plans
Result/Aftermath
Impeachment/imprisonment of some of the government officials and company officers involved; financial ruin for many speculators

 

Railway Mania

Description
Economic expansion fuels speculative investments in both legitimate and illegitimate railroad endeavors.
Era/Economic Environment
Booming British economy with a literate middle class looking for investment opportunities after the Bubble Act (created after the South Sea Bubble) was repealed in 1825
Peak 1846
Where Great Britain
Ground Zero Industrialists
Widest scope Unknown
Enabling Financial Condition(s)
Lax regulatory environment (“laissez faire capitalism”), new investors seeking dividends (“dumb money”), subscription shares (leverage)
Trigger (if any)
Rapidly decaying economic environment (for more information look up the Irish Potato Famine)
Result/Aftermath
“A giant and very speculative undertaking that succeeded”. Many households lost their investments/savings, but the UK gained over 6k miles (approx 10k km) of track.

 

Black Tuesday

Description
Excessive (leveraged) speculation, now-criminal banking practices, and fraudulent investment schemes in a time of great economic prosperity leads to spectacular market crash and the Great Depression.
Era/Economic Environment
Roaring 20s – economic prosperity in the Western world
Peak Oct 1929
Where US
Ground Zero Stock Market
Widest scope World
Enabling Financial Condition(s)
Economic and technological booms
Trigger (if any)
Lackluster economic data, LSE crash triggered by the incarceration of key investors, unstable trading activity, margin calls on highly levered positions, tightening Fed policy, Hawley–Smoot Tariff Act
Result/Aftermath
the Great Depression

 

Automobile Manufacturing

Description
By 1930, according to wikipedia over 1,800 automobile companies had been created and subsequently disbanded in the United States alone. Not a bubble, per se, but an example of many investors chasing innovation and returns.
Era/Economic Environment
Early 20th Century
Peak Arguable
Where US
Ground Zero N/A
Widest scope N/A
Enabling Financial Condition(s)
See Black Tuesday
Trigger (if any)
Great Depression
Result/Aftermath
Industry consolidation leaving “the Big Three” major companies in the US

 

Beanie Babies

Description
Stuffed bears retailing for $20 were valued at hundreds of thousands of dollars in the 90s.
Era/Economic Environment
90s Economic Boom
Peak 1999
Where US
Ground Zero
Teachers and Housewives in Chicago
Widest scope Unknown
Enabling Financial Condition(s)
Ebay – the emergence of P2P commerce
Trigger (if any)
Prices did not increase as expected after a routine retirement announcement
Result/Aftermath
No widespread economic impact; the current value of the stuffed animals is unclear. Recent eBay auctions show “Princess Bears” still selling for as much as $15k. Presumably these are fraudulent transactions or naive buyers.

 

Tech Bubble / Dot-Com Boom

Description Excited about the internet, investors piled cash into anything claiming to be even remotely related to technology.
Era/Economic Environment 90s Economic Boom
Peak 2001/2002
Where US
Ground Zero Silicon Valley
Widest scope Investors worldwide
Enabling Financial Condition(s) The internet
Trigger (if any) Arguable – possibilities include high real interest rates, telecom crash, the September 11th attacks, and the slowing/stopping of venture capital.
Result/Aftermath Trillions of dollars lost, “nearly 5,000 Internet companies [were] either… acquired or shut down in a massive sector consolidation.”

 

Housing Bubble (US) / Subprime Mortgage Crisis

Description Mistrusting stocks after the tech bubble, investors pile into real investments. Securitization and lax lending standards fueled the fire.
Era/Economic Environment Strong economic growth
Peak 2007
Where US (similar bubbles happened worldwide)
Ground Zero Housing Market
Widest scope Anyone with a real estate investment
Enabling Financial Condition(s) ABS/MBS
Trigger (if any) Weak economic growth, unservicable debts (e. g. option ARMs)
Result/Aftermath The Great Recession

 

 

 

A note to Bitcoin investors:

Sorry about the timing of this article. I’ve been working on it for quite awhile.

 

Disclosures (15 Jan 2018):

* shoutout to The Options Insider Radio Network for talking about this one – I felt like I was the only one trading this stuff. I currently have no position in Canadian cannabis stocks.

** I’m long all three.

*** I occasionally trade cryptocurrencies but have no position at this time.

 

Further Reading and References:
https://en.wikipedia.org/wiki/Tulip_mania
http://www.academia.edu/149695/_The_Tulipmania_Fact_or_Artifact_

https://en.wikipedia.org/wiki/South_Sea_Company
https://www.investopedia.com/features/crashes/crashes3.asp
https://www.britannica.com/event/South-Sea-Bubble
https://www.library.hbs.edu/hc/ssb/history.html
https://www.tse-fr.eu/sites/default/files/medias/stories/SEMIN_11_12/FINANCE/goetzmann.pdf
https://en.wikipedia.org/wiki/Jonathan%27s_Coffee-House

https://en.wikipedia.org/wiki/Railway_Mania

http://www.dtc.umn.edu/~odlyzko/doc/mania01.pdf

https://en.wikipedia.org/wiki/Wall_Street_Crash_of_1929
https://en.wikipedia.org/wiki/Pecora_Commission
https://en.wikipedia.org/wiki/Roaring_Twenties
https://www.britannica.com/event/Great-Depression

https://en.wikipedia.org/wiki/List_of_automobile_manufacturers_of_the_United_States
https://www.britannica.com/topic/automotive-industry
https://alfred.stlouisfed.org/series?seid=A01154USA471NNBR

https://en.wikipedia.org/wiki/Beanie_Babies
https://nypost.com/2015/02/22/how-the-beanie-baby-craze-was-concocted-then-crashed/
http://www.tycollector.com/the-scoop/princess-bear.htm
https://www.ebay.com/sch/i.html?_from=R40&_sacat=0&LH_Complete=1&LH_Sold=1&_mPrRngCbx=1&_udlo=5%2C000&_udhi&_nkw=beanie%20babies&_dcat=440&rt=nc

https://en.wikipedia.org/wiki/Dot-com_bubblehttps://web.archive.org/web/20031203183731/http://www.webmergers.com/data/article.php?id=67

2017 in Review

Happy New Year, hope you had a good holiday.

A few questions for 2018:

  • Will equities continue to rally?
  • Similarly, will the yield curve invert and herald the next recession?
  • Whatever happened to inflation?
  • What forces will dominate oil prices in the upcoming year – Saudia Arabia/OPEC, shale production, alternative energy, or something else?
  • What effect will tax reforms really have on the market?
  • What will end the credit rally?
  • Bitcoin?
  • More broadly, which cryptocurrency will become dominant?

 

When looking to the future it helps to sum up the past. We’ve put together a selection of broad market visualizations for you to peruse. Volatility was predictably low (see distributions below correlation matrix). Equities went gangbusters. The curve flattened.

Securities included * :

SP500 – S&P 500 index (not total returns)
WTI – West Texas Intermediate Crude Oil
Brent – Brent Crude Oil
Gold – Gold, Fixing Price in London Bullion Market
HH NG – Henry Hub Natural Gas
Bitcoin – Bitcoin Prices from Kraken
VIX – CBOE Volatility Index
LIBOR – 3-Month London Interbank Offer Rate

* Unless otherwise noted, data is from FRED

 

 

S&P 500, WTI, Brent, Gold, HH NG, Bitcoin

Data is daily percent change for the given year with 2017 in green and 2016 in grey. All graphs are normalized; axes are the same scale for comparison. Extreme values are binned into the outermost values (visible in Nat Gas and Bitcoin).

VIX

Data is daily change for the given year with 2017 in eggplant and 2016 in grey.

Fixed Income

Data is daily change in yield (basis points) for the given year with 2017 in blue and 2016 in grey. All graphs are normalized; axes are the same scale for comparison. Extreme y-values near the middle (zero) are cutoff for dramatic effect.