September 11 , 2008

In Search of the Next Bubble

SOME BUBBLE HISTORY

A look back over the last few hundred years of economic activity reveals that economic bubbles are anything but unusual. Indeed, in Holland during the 1600’s, the world experienced the now infamous “Tulip Mania”, and there are records of single tulip bulbs being exchanged for 12 acres of land. At the peak of the mania, tulip contracts sold for more than 20 times the wages of a skilled craftsman. Of course, this bubble ended as all bubbles, inevitably, do. In 1637 tulip bulb prices suddenly collapsed, fortunes were lost, and the negative effects of the crash reverberated throughout the Netherlands for years.

In June of 1720, after experiencing what was known as the South Sea Company stock collapse, the economic reverberations were severe enough to cause England to pass what was known as the “Bubble Act.”

 Of course in our country, there has been no shortage of bubbles, especially in recent times. We had the great stock market crash of 1929, the tech collapse of 2000-2002, the real estate crash of 2007-2008 and perhaps the commodity crash of 2008-2009.

ANATOMY OF A BUBBLE

The pattern of a bubble is quite familiar to us by now. A steady rise in the price of a commodity, stock or financial instrument is followed by a speculative frenzy where prices are driven higher and higher.  Speculators begin to borrow and leverage themselves in order to buy more of the now sizzling hot investment. Cooler heads begin to warn the public about the unsustainable, precipitous rise in price. These advocates of reason and rational thought are greeted with the response that ,“this time things are different”, as investors convince themselves that circumstances surrounding this particular   asset run-up renders any prior history of bubbles obsolete. At the end of the bubble cycle, after some triggering event causes a drastic sell-off, prices may be driven even lower than the true value of the asset warrants,  as too many sellers all rush to the exits at the same time. At this point, true value investors may swoop in for easy profits and the cycle can begin again.

IS THERE A SILVER LINING?

In his book Pop, Why Bubbles are Great For The Economy, Daniel Gross argues that there are some benefits to society resulting from bursting bubbles. For example, while many investors lost fortunes in the recent “dot-com” bubble, much of that invested money was used to build the software and infrastructure now powering the internet. If I extended that line of reasoning to today’s sub-prime mortgage debacle, I would argue that all of those empty condos in South Florida will eventually be sold at lower prices to buyers who would never have been able to afford them. Indeed, there has been some talk about the City of Miami taking over a condo project or two in order to provide reasonably priced housing sorely needed for City employees.

THE NEXT BUBBLE

After participating in and observing financial markets for almost 30 years and studying hundreds of years of market history, I can predict with certainty that the next bubble is on the way. In fact, recent bubble history suggests, that because of our current 24/7, seemingly steroid charged mass media coverage of economic events, the bubble cycle has become accelerated, and the next one is around the corner (Did I mention Jim Cramer?).

So why focus on the next bubble---2 reasons. The first reason is that those that get in early on a trend can actually make some money if they get out before the train wreck occurs. Secondly, for the rest of the crowd that normally comes too late to the party, it gives them a reason to stay home and sit it out.

So where is the next financial bubble going to manifest itself? I am going to look at the financial services industry for the answer. In the late 90’s the financial services industry brought us scores of tech and internet offerings. In the mid-part of the current decade it offered a host of new mortgage and real estate selections. In the last couple of years, virtually every financial services company added oil and commodity offerings. And now, drum roll please, what are the latest products from the industry? The answer is infrastructure and alternative energy investments.

Now, you need to put what I’m writing in the proper context. I firmly believe, as I think we all do, that the country and world need to prioritize investment in infrastructure and alternative energy. Much of the new monies that will be flowing into these industries will be put to good use and can result in profits for investors, especially those who enter early in the cycle. However, there may come a time when, perhaps, too much money flows into this sector; when highly leveraged companies with no profit potential enter the arena; when prices begin to soar, causing investors to become “irrationally exuberant.” Finally, when you begin to hear, “this time things are different,” you will know what will probably follow next---Pop!

Austin A. Frye, MBA, JD, CFP®

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