Economic bubbles

Girl bursting bubbles

There is a common misconception that classifying things as economic bubbles imply that it is worthless. It just means that it is valued much higher than its intrinsic value. A typical definition states that an economic bubble is an investment that is bought simply because everyone assumes that it will be worth more tomorrow, for no fundamental reason.

This is known as the Greater Fool Theory. We buy an investment simply because we expect the next person will be willing to pay more for it than we did. That is until they don’t and the bubble metaphorically bursts. Let’s look at some bubbles that we have experienced in the past.

Dot-Com bubble

The internet started catching on in the 1990s and people were losing their shit about it. Until 2000, if you were doing anything on the internet people assumed you were making bucketloads of money. Share values skyrocketed. People were pouring capital into anything that ended with .com and speculation reigned supreme. This while a lot of companies were making a loss and spending a fortune on marketing.

In March of 2000, the Federal Reserve raised interest rates and the extreme levels of debt haunted a lot of these companies. Then companies started failing. Online stores failed first, followed closely by communication companies. Some companies had their share prices plummet (think Steinhoff plummet) and barely survived.

Withing 7 months internet companies shed 75% of its market cap. Some companies had a good business backing their share prices and pulled through, coming out better than ever. Amazon is an excellent example of one such company but they were the exception to the rule.

Housing bubble

A good indication of what the price of a property should be is the replacement value. The price of houses fluctuates around this baseline naturally. Otherwise, you would simply build the property from scratch and sell it for massive profits (which is what a lot of people do in housing bubbles to be fair).

After the .com bust in 2000, the interest rates in the US was dropped to 1% to stimulate the economy. This led to access to massive amounts of low-interest debt. What do people do with low-cost debt? Buy expensive shit obviously. With a lot of money chasing the same properties, the prices started to soar.

As the economy started returning to normal, so did the interest rates. This led to a lot of people defaulting on their home loans. Prices of homes started falling and a lot of people owed more on their properties than they could sell it for. This also meant that when people defaulted on their loans, banks struggled to auction the properties for more than the outstanding debt. These factors led to the recession of 2008/2009 which most people will still remember.

Tulip bubble

Aah, the grandfather of all economic bubbles. To this day “Tulip Mania” is used for describing economic bubbles. It probably wasn’t the first bubble and happened in the 1630s. At the height of the Tulip bubble, bulbs were selling for about 10 times the annual salary of a skilled worker. To put that into context, that is about R1.7 million in today’s money. Looking back, it is easy to see how this was a bubble if you were paying R1.7 million for a flower bulb.

The tulip originally came from Turkey and was cultivated in large numbers in what we today call the Netherlands. It grew in popularity simply because it had intense colours not seen in Europe before. The Netherlands was at the heart of the East India Trade (topic for another day) and its population was printing money. The tulip became a status symbol of the rich.

In February of 1937 tulip traders started struggling to sell the tulip bulbs. The demand fell and the prices plummeted. The demand for tulips was replaced by a massive demand for Hyacinth flowers. Yes, the same plants we are struggling to remove from our dams today. To this day, every economist quotes the tulip bubble as an example of how irrational people can be about the housing market, stocks and bitcoin.

1929 stock market collapse

In the 1920s, optimism about the stock market was at an all-time high. The car industry was booming and people were speculating on shares. With drastic growth in share prices, people leveraged their portfolio to increase their returns. In other words, invested with money they borrowed. When the stock market started to slow down, banks stepped in to artificially inflate prices. Over this seven-year period, prices grew by 20% each year.

The problem was that the company profits did not support this massive growth in share prices. Coupled with this, the Federal Reserve raised interest rates, making the debt unaffordable. The stock market came crashing down. People rushed to the banks to withdraw their money, who by this time had also lost everything in the stock market. This led to numerous bank failures as well. A lot of people lost all of their life’s savings and unemployment went up threefold. Historical events mean nothing if we do not learn from them.

What causes economic bubbles?

Herd mentality. In 1841 a book called Extraordinary Popular Delusions and the Madness of Crowds was published. Charles Mackay explained how tulip mania was caused by the irrationality of the crowd. Everyone is buying something for an insane amount. They can’t all be wrong.

Extrapolation. We see how much something has grown in value and immediately assume that it will continue growing at the same rate. That is when the fear of missing out kicks in and we get in as soon as possible.

Greater fool theory. The price keeps on rising and since we assume it will continue rising, we assume there will always be someone to buy it at that inflated price.

Debt. If the debt is too cheap, people start buying things with money they do not have. Especially if it is assumed to continue growing. If it then starts falling or the interest rate increases, some people are screwed.

Spotting a bubble

People tell you that you are an idiot for not investing, without being able to explain why you should invest and what the fundamentals are. Predictions of future value will start getting extreme. Then you will notice that the ratios are off. The price to earnings ratio for shares will be high. It will be significantly cheaper to build the house than to buy it. These are all examples of the ratios being off and you should be cautious. Finally, at the very end of the bubble, non-investors will start investing.

What does this mean for us now?

From previous economic bubbles, we have learned a few important lessons:

  • Don’t borrow money to invest unless you can afford the debt.
  • Don’t buy something that you know is overpriced simply because you think someone else will be willing to pay more for it. You might be the last fool.
  • Don’t bargain on interest rates, or any other crucial metric, to stay the same.

There has been a lot of talk about bitcoin being a bubble in recent times (yes I’m going there because I will get comments about it anyway). The problem is that it is difficult to value bitcoin. Usually, you would value a currency based on the economy behind it. Something bitcoin does not have. So, we value bitcoin based on the technology behind it. Is it worth something? Yes. Can I value it correctly? I have no fucking idea where I would even start. For all I know, it is worth billions, but I won’t be finding out. In hindsight, we will know its exact worth.

Be safe out there,

Hendrik

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