In 1636, Holland was one of the world’s wealthiest countries, its ships controlling much of the Asian trade, and its bankers made it a strong financial capital. Then, suddenly, the economy of Holland went crazy. Huge fortunes were made in months, and entire estates liquidated, all in order to invest in….tulips.
While the average Dutch person had an annual income of 150 florins, a single tulip bulb sold for as much as 6000 florins, more than a lifetime’s income. A lucky trader or speculator could earn a similar amount each month, and tulips were traded on the stock exchange. “Futures markets” started, with people signing contracts to purchase tulips the following year for 10 times the current market prices!
Then, in 1637, enough people decided that paying such high prices for an easily cultivatable flower might not be the smartest idea after all. The price for tulips crashed almost overnight, leaving many unwise investors financially ruined, and plunging the Dutch economy into a multi-year depression.
This was an example of a price bubble bursting. A price bubble exists when the price of an asset or collectible rises to great heights, then suddenly collapses, just like a soap bubble can inflate to great size, then suddenly burst. The most recent example of a bubble bursting is the housing bubble, where average home prices have fallen by at least 10% in the past year. To understand how and why bubbles form, we need to understand four factors which affect the valuation of assets.
Income-producing assets include rental housing, corporate stocks, bonds, and other financial derivatives, as well as direct ownership of businesses. The value of these assets is, in theory at least, equal to the present value of the expected future earnings from the asset.
The lower the interest rate, the higher the cost of housing and other assets. In the case of housing, people compare how much they will pay in rent to their monthly mortgage payment. As a rule-of-thumb, if the monthly mortgage payment is lower than rent it makes sense to buy, and if it is substantially higher than rent it does not. Lower interest rates mean lower monthly mortgage payments. For example, on a 30-year mortgage, if the interest rate is 4% payments are only two-thirds as much as when the interest rate is 8%. Or, to put it another way, when interest rates are 4% rather than 8% you can borrow 50% more money while making the same monthly payment, so real estate can be priced 50% higher and still be worth buying.
In the case of a stock or bond, people compare the expected returns on a stock with how much money they would earn by putting money in the bank and collecting interest, and similar calculations apply. Thus, very low interest rates, as the United States had under Alan Greenspan (chairman of the Federal Reserve 1987-2006,) cause asset prices to rise, then these prices decline as interest rates rise.
While the method seems simple for an asset with a clearly defined regular payment, it gets more complicated, as payments may change in the future. For example, if you expect that a neighborhood will have a higher demand for housing — and higher rents — in the near future, you will pay more for the housing than today’s rent will justify. (And the reverse is the case if you think the area is economically dying.) Similarly, some companies pay no dividends to stockholders, and may even lose money, but their stocks are highly valued because people expect them to be very profitable in the future.
As we have seen above, expectations about the future are already fully accounted for in the fundamental price of homes and other income-producing assets. However, many people, including sophisticated Wall St. operators, base their valuations not on fundamentals, but on current prices and trends, generally assuming that rising prices will continue to rise and falling prices will continue to fall.
The problem with expecting trends to continue is that the expected future value is already fully accounted for in the fundamentals. Thus, if something is expected to become more valuable (or a company more profitable), then meeting these expectations should not change the price.
Bubbles happen when too many players in a market assume that rising prices will continue to rise. Fortunes are made by those who buy early and sell when prices are high, and are lost by those who buy just before a bubble “bursts.” Price bubbles have happened many times in ancient and modern history. Recent examples in the United States are silver in 1980, Beanie Babies in the mid-1990s, and internet-related company stocks. These “dot-com” stocks rose dramatically in the late 1990s through 2000, before the bubble burst in 2001. The current real estate bubble, with less sudden drama but more economic impact, has deflated roughly 15%, more in some areas, starting in 2007.
Within the music industry there are there analogous phenomena to bubbles. For example, in 1997, Warner Music signed an $80 million deal—the largest in music history at that point—with R.E.M, which had had a string of top-selling albums. Since the deal was signed, R.E.M. has released 3 albums: One went gold but not platinum; the others failed to go gold in the United States. While R.E.M. remains a well-respected band, Warner lost tens of millions of dollars on that deal.
Similarly, when Napster became a public company in early 2002, many people bought the hype: its stock traded at $10 per share. This climbed up to $15 by mid-2002, then lost half its value overnight. As of the writing of this article, one share of Napster stock sells for $1.85.
Remember the Fundamentals!
Bubbles happen, and it is impossible to predict where. To avoid catastrophic financial losses, always keep your eye on the fundamentals. If you are purchasing a house to rent out to others, compare the price of the house to the expected rental income (after expenses). When purchasing a stock, compare the share price to how much profit per share you think the company will be making. When considering signing a band to your label, do a realistic assessment of how much the band will earn you. Do not get carried away by the recent trends.
Then, if prices go far higher than they have any right to, by all means sell! And in a couple of years, when the dust settles and the news media are ruing the misfortunes of those who bought at the wrong time, you will be sitting on a large pile of money. Try not to gloat.
By Kevin Block-Schwenk