Bubbles – Part I

November 4, 2014

star-trek enterpriseBubbles, the final economic frontier.  This is the voyage of the Market.  Its multi-year mission is to explore strange new manias; to seek out new players and new sources of credit; to boldly go where no Market has gone before.   (Star Trek music playing in the background).

While a “bubble” is not as vast as the space explored by the starship Enterprise, it can trap many unsuspecting investors within its boundaries.   A bubble, for the purposes of this article, is a speculative mania directed towards investment.  The investment can be anything from stocks, bonds, or real estate to something organic like a flower.  Yes, you read that correctly, a flower! 

The bubble manifests with investment at levels previously unimaginable.  This occurs when the implied value of the investment greatly exceeds its intrinsic value. Rationalization of implied value is always abundant.  Once investors understand they’re in a bubble, they head for the exits. 

Suppose a company produces bobble head dolls of St. Louis Cardinals pitcher Seth Maness and sells them for $4.00.  The company calls these dolls “SethPet”.  The company distributes the dolls to local retail outlets and sales are commensurate for a player of Mr. Maness’ ilk to command (Seth is a relief pitcher who began his career in 2013).  To spur sales of the SethPet, the Cardinals have a SethPet bobble head doll night at Busch Stadium. Children love them!  The retail price of the doll remains $4.00. 

Then something interesting happens.  The company creates a Twitter and Facebook page for the SethPet.  Soon, children and teens are flocking to Facebook and Twitter for daily updates on the SethPet.  Cell phone traffic experiences a pronounced increase.  The hashtag #SethPet begins to rank high in searches. The company cannot keep up with orders and announces a doubling of the price. 

The Cardinals appear on the ESPN Sunday night game and the announcers mention the SethPet doll craze.  The game receives international attention and now orders for the doll come from overseas.  Enterprising youngsters, who earlier bought extra dolls, auction their supply on eBay.  Dolls are fetching as much as $20. 

The company’s marketing department develops a limited edition SethPet selling for $50.  Limited edition models appear in eBay with $100 sales commonplace.  An astronaut aboard the ISS cozies up to a SethPet during a news interview.  When returning from space, the astronaut auctions the SethPet for $1,000.  

As luck would have it, Seth Maness, the pitcher, hurts his arm and is disabled.  The Cardinals experience a bad season.  Without the constant media exposure, interest in the SethPet wanes.  Parents openly question the price of the doll.  eBay auctions are no longer lucrative.  The St. Louis teen community, which had so thoroughly embraced the SethPet, focuses on the next app for their smartphone.  From a peak of $1,000, the SethPet sits unsold on retail shelves until its production ceases.  Those who had bought SethPets for “investment” purposes tried in vain to dump them.  Eventually, a Chinese distributor offered $0.50 for each doll. 

While the previous example dramatizes speculative bubbles, such manias are a part of investment history.  An early recorded speculative bubble was the Tulip mania in Holland from November of 1636 to May of 1637 (the flower reference from earlier).  At the mania’s peak, the tulip price increased by a factor of 20.  After peaking in February of 1637, tulips fell to their starting point a mere three months later.  Perhaps more importantly, at its peak, the price of a tulip was 10 times the yearly wage of a skilled craftsman. 

Manias occur due to the innate human instinct of herding - investors are followers.  Manias climb a “wall of worry”.   People are afraid of being left out of what they perceive is broad participation (everyone is doing it so it must be good).  The rationality of the herding impulse is ignored during the bubble.  Few recognize they are in a bubble which is why so many are caught in it.

It takes keen discipline, or a detached investment analysis to understand bubbles.  Alternately, you could implant Mr. Spock’s Vulcan brain as your own and understand that most speculative bubbles are “illogical”.

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Jim Mosquera is the author of Escaping Oz: Protecting your wealth during the financial crisis. The book discusses how the public will greatly misinterpret the capabilities of our financial Wizards and what they should do to shelter their investments. Jim is a Principal at Sentinel Consulting a business restructuring, capital acquisition and economic consulting firm. He operates the financial and economic site The Sentinel. You can email him here: jim@thesentinel.biz

Jim Mosquera is the author of Escaping Oz: Protecting your wealth during the financial crisis. The book discusses how the public will greatly misinterpret the capabilities of our financial Wizards and what they should do to shelter their investments. Jim is a Principal at Sentinel Consulting a business restructuring, capital acquisition and economic consulting firm. He operates the financial and economic site The Sentinel. You can email him here: jim@thesentinel.biz
The symbol for silver ‘AG’ comes from the Latin word ‘agentum’ meaning silver.