Saturday, 23 July 2011

Come and Ride the Bubblecoaster: Riders at the Back Will Get Wettest! (Part 1 of 2)

Stories of investment 'booms and busts' abound. Sometimes they're called 'bubbles' and the word 'bust' is changed to 'burst' because......... that's what bubbles do. I use the words 'bust' and 'burst' interchangably. 
The word 'mania' can used instead of 'bubble'. They mean the same thing: the price of an asset (or asset class) gathers such upward momentum that people trade the asset for increasingly ridiculous prices relative to the how the asset was previously valued. The price is chased upwards until it reaches a peak and then plunges like a lead balloon.

At the peak of big bubbles, although humans are unaware, spacecraft are rumoured to have been spotted in the sky as alien news reporters are dispatched from outerspace to report on the bizarre behaviour of those involved in the bubble. ;-)

In part one, I would like to take a closer look at the common features of bubbles and, in part 2, I will see how human behaviour contributes, and is affected, by them.

First, these bubbles have been around for a very, very long time - I suspect since man first started to hunt, gather and swap things with his neigbours: the human need to accumulate possessions and things of value is a powerful force.

Add to that the realisation that certain objects were scarcer than others plus the urge to keep up with his neighbour, Caveman Jones, and you can see the elements for bubble creation are all in place. Maybe there was once a Mammoth Jaw Bone Bubble but we don't know because records don't go back that far.

It is important to note that bubbles can form in whole economies, sectors, commodities and asset classes etc. In fact, just about anywhere a tradeable asset can be found, a bubble can form.

Handy adjectives are added to make 'stockmarket bubbles', 'economic bubbles', 'property bubbles', 'currency bubbles'. They are still bubbles. If it inflates like a bubble, pops like a bubble and looks like a bubble, it probably is a bubble.

We do know about The South Sea Bubble that popped in 1720, the Dutch Tulip Bubble that popped in 1637, the bubble that popped in 2000. Those were the most famous ones - I assume due to the sheer number of people who were suckered into diving in head first and then had to face the hard landing.

A quick look on Google will give you lots of information on others: railways, uranium, biotechs, property, exotic livestock, Celtic Tiger..........the list goes on. I won't go into individual bubbles in this article because, for the purposes of this article, you only have to know and agree they exist.

I'm sure Gordon Brown, in his early days as the Chancellor, once said that he wanted to get rid of the boom/bust cycle. Nice in theory but in reality he'd need to change human behaviour.

In simple terms, bubbles form because there is too much money chasing something in short supply.

It is my belief that bubbles inflate over a much longer period of time than the majority of private investors are aware of. It may seem that the bubble (price rise) has inflated very quickly but I think that is because by the time the majority of smaller investors become aware of the bubbling asset, those in the know have already had their fill before 'critical mass' was achieved.

The thing about bubbles is that they always seem to form around things that the average man (or woman) on the street doesn't have much experience of. They always seem to be formed around things that are slightly mysterious, exotic or disruptive: post-it notes were a revolution in their time but I don't seem to recall a post-it note bubble. Perhaps post-it notes were simple enough to be understood by Mr or Mrs Average and so couldn't be overhyped. I'm currently watching gold and Rare Earth Metals as potential bubbles.
The internet may help to alleviate the above disparity in knowledge, but again I have my reservations. Especially as the internet can be a good source of information and equally a good source of utter tut.

During bubbles, some canny operators apply the 'greater fool' theory. This means that although Mr Canny Operator thinks that the asset he is buying is grossly over-priced, he may still buy it because he is highly confident that he can sell it on shortly, at a higher price, to some 'greater fool'. More diplomatic souls develop this trading strategy and call it 'momentum investing'.

Conversely, bubbles end when the price of the associated asset plummets, sometimes for no obvious reason. What is in no doubt is that when bubbles burst, they burst extremely quickly, some say spontaneously. The aftermath is hard and like a broken leg, it may take seconds to break and months to heal.

Another thing about bubbles is that they can only be labelled as bubbles in retrospect. In the midst of a bubble, some people (who I will call 'bubble callers) give warnings, which are usually ignored. When they are not ignored, they are usually slammed as overdone pessismists - especially by those filling their boots, and enjoying the short term price rise, with the bubbling asset. The only people who take note of the bubble-callers are other bubble callers so it's a bit like preaching to the converted.

Ironically, these bubble callers are usually feted for their foresight once the bubble bursts. Until the next bubble starts growing and they get ignored all over again.

For the sake of presenting a fair and rounded picture, I should say that some clever academics and economists claim that bubbles can be caused by things other than short supply, a good story and human behaviour. I don't understand them.

I have written about my first experience, as an investor, of a bubble here at Dotdoom Fever- a Historical Story .

In the next installment, I will write about the emotions associated with the boom and bust phenomenon associated with bubbles.