No Tree Grows to the Sky a Cautionary Tale About Manias and Bubbles

No Tree Grows to the Sky A Cautionary Tale about Manias and Bubbles

Introduction

“This time is different.” “It’s a new economy.” “The world has changed.” “Better jump in before it’s too late.”

Sound familiar?

Whenever you read headlines like this in your local paper or hear such snippets on the cable news channel, guard your wallet and recall three quite different quotations:

• “There’s a sucker born every minute.” – P.T. Barnum 1

• “No tree ever grows to the sky.” –An old German proverb, often used on Wall Street 2

• “Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble . . . to give way to hope, fear, and greed.” –Benjamin Graham, the father of value investing

Economic manias and booms are as old as civilization itself. While the beginnings and ends of these speculative fevers are difficult to predict, the savvy entrepreneur takes great care not to blindly participate, preferring to profit from—or at least not be a victim of—the madness of crowds that always ends so badly.

A Brief Review of Major Manias and Panics

The Tulip Mania

One of the earliest recorded bubbles is the Tulip Mania in Holland, which reached its peak in the early 17th century.3 It wasn’t uncommon for a single tulip bulb variation in particular—called the Broken Tulip for its vibrant splash of a fiery red upon a stark white—to sell for the equivalent of

1 Barnum denied every saying it. 2 This proverb was a favorite of Winston Churchill. 3 Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. Scottish journalist Charles Mackay, 1814-1889

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$250,000 today. And at the mania’s peak, one of these bulbs sold for a price equivalent to the value of the grandest canal house in Amsterdam.4

For reasons still unclear, Tulip Mania swept Holland, and many early investors grew rich. Rare tulips became a status symbol. Tulip bulbs began to trade on various exchanges, and an active paper-futures market in tulip bulbs appeared. Some people sold most of their belongings to purchase a single bulb, believing that the craze would last forever, and that there were no bounds on the price of an extremely rare flower. Soon members of every socioeconomic group, from chimney sweeps to royalty, were buying, selling, and hoarding bulbs.

Then, in February of 1637, the market peaked. Finding buyers became difficult, and the value of tulip bulbs plummeted. In the end, there was 40 million guilders in tulip debt—six times the amount of all the money in circulation.5 Entire family fortunes were wiped out. Some courts refused to enforce tulip contracts, holding that the agreements were more akin to gambling than investing.

And here’s the kicker: That variation of tulip—as scientists and historians much later discovered—wasn’t its own species at all. That fiery red-and-white pattern that the Dutch thought was the epitome of beauty was, in fact, the result of a botanical virus.6

The irony couldn’t be sharper: The fever that swept the Dutch like a virus was a virus.

The South Sea Bubble

A second great early mania was the South Sea bubble in early 18th century Britain. The South Sea Company, which had few assets, was granted a monopoly right to trade with Spanish colonies in South America.

Actual trade with Spain was minimal, but holders of illiquid War of Spanish Succession bonds were delighted to find that they could swap their low-yielding British government debt for equity that seemed to keep climbing in price. From a price of £100 a share in late 1719, the South Sea Company’s stock rose to over £1,000 per share by August of 1720, despite the fact that it had little in the way of legitimate business.

Government officials, who as political favors had been granted what were in effect free options, enthusiastically and publically endorsed the scheme. The company also published lists of famous and powerful shareholders to add an air of legitimacy to the business. Many shareholders used large amounts of debt to buy additional shares, leading to explosive returns on minimal equity.

Once the speculative bubble burst and everyone realized that the value of the Succession bonds had been dramatically inflated, the stock price plummeted. By September the price per share had declined back to £150. Many individuals, including members of the aristocracy and high government officials, were ruined.

4 Pollan, Michael. The Botany of Desire. New York: Random House, 2001. 5 Ibid. 6 Ibid.

Modern Manias: the Dot-Com Bubble, Peak Oil, and Subprime Mortgages

There have been scores of manias and speculative fevers since 1720, most notably the railroad trusts in the 1840s, the automobile craze in the 1920s, and the conglomerate mania in the 1950s and 60s.

More recent examples of manias, booms, and busts include the dot-com mania of the late 1990s, the commodities boom in the early 2000s, and the housing boom and bust of the late 2010s.

The Technology Craze Exciting real advances in computing power led to a technology boom in the mid 1980s, which culminated in the birth of the Internet craze in the mid 1990s. Soon a self- reinforcing cycle of early-stage venture capital investments in high-tech startups, followed by initial public offerings, drove the NASDAQ—the home for many high-tech companies—from under 1,000 in 1995 to over 5,000 by early 2000 (Figure 1).

Figure 1: The dot-com bubble

One early example of the technology craze was the Winchester disk drive boom of the early 1980s. Venture capitalists invested over $270 million in over 70 companies chasing the same narrow markets.

If those companies had actually met their projections in this industry niche—which was known for products with rapid technological obsolescence—the value of the disk drive industry would have surpassed the combined value of most of the leading industrial companies in America.7

Later, in the 1990s and early 2000s, many dot-com founders became billionaires through stock options and initial public offerings, even though their companies barely had revenues, much less substantial profits. Most dot-coms never reached breakeven cash

7 Sahlman, William and Howard Stevenson. Capital Market Myopia. HBS note 9-288-005. Boston: Harvard Business School, 1998.

flows and far fewer returned the sunk costs that had been invested. Price-earnings ratios became irrelevant for companies with no earnings, and valuation metrics shifted to non- financial measures like “eyeballs” on a website. Most companies seemed propelled by a “land rush” mentality, with many firms chasing the same markets.

Many industrial companies jumped on the dot-com bandwagon too, multiplying their equity valuations simply by having a “dot-com strategy” or by appending “com” to the name of a subsidiary. A prime example of these industrial companies was Enron, a company that quickly morphed from a sleepy oil and natural gas pipeline company into a $100 billion natural gas trading company and then into a firm that made markets in futures and derivatives in commodities from natural gas to electricity to weather to broadband capacity.

A Boom in Crude Oil Prices During the late 1990s and early 2000s, a speculative commodity boom also erupted, most notably in the price of crude oil (Figure 2). Spurred by concerns about increasing Chinese oil demand and a peaking of world oil production (a warning that had been echoed every few decades since commercial quantities of oil were found in the late 19th century), oil prices rose from an average of $15 a barrel in 1998 to over $92 a barrel in 2008 (with an absolute peak of around $147), before falling back to $70 a barrel by 2010.8

Figure 2: Crude oil boom

The Rise and Collapse of U.S. Housing Prices

The latest boom and bust occurred in U.S. housing prices, fueled by government- subsidized mortgage rates, which were in themselves a product of the Federal Reserve’s campaign to rescue the economy from the dot-com bust. Belief that house prices would go

8 Figures adjusted for inflation.

up forever enticed many Americans to take on subprime mortgages for far larger homes than they could afford.

Figure 3: The Case-Schiller Home Price Index: The boom before the bust

By mid 2006, housing prices had peaked (Figure 3) and had begun to fall. The resulting crash of the value of subprime mortgages—which came into sharp relief in the fall of 2008—nearly led to the collapse of the world financial system, which was rescued, at least temporarily, by unprecedented infusions of cash and guarantees from government bailouts.

What Causes Manias and Booms?

Even after centuries of recurring manias, booms, and busts, there is no agreement about what causes the wild gyrations. Some believers in the “efficient market theory” even doubt that manias exist, holding that markets at all times reflect the rational expectations of all participants.

But recent findings in behavioral economics—as well as centuries of rapidly inflating booms, followed by dramatic busts—suggest that most investors are anything but rational. More skeptical observers tend to side with the P.T. Barnum mentality: Many are suckers who simply want to believe and participate in get-rich-quick schemes.

Manias and booms are frequently accompanied by the following:

1. An excess of money being printed by governments The supply of paper currency is not fixed. The central banks of governments can increase the supply of paper currency and decrease short-term interest rates in an attempt to boost the economy. Often these increases in money supply create bubbles of liquidity that travel between the stock market and hard assets, as some investors search for higher interest rates and others seek a haven to protect from inflation.

2. An excess of credit Related to an increase in money supply is an increase in credit. When short-term interest rates are artificially depressed and financial liquidity is high, banks have a strong incentive to loan large amounts of money, particularly if it generates fee income. This increases the banks’ stock prices and makes bank executives’ stock options more valuable.9

The availability of large amounts of non-recourse leverage increases speculative fever, because a 500 percent increase in stock market or asset prices, with 90 percent leverage, can generate a 50:1 return on equity for speculators.10

3. A widespread belief in the power of a new technology or societal change Generally booms are accompanied by a widespread, popular belief in some sort of societal change. It could be the Utopia of cheap rail transportation, electricity, automobiles, or the Internet. Or it could be the doomsday predictions of climate change activists or of those that say that oil production is peaking.

4. Misaligned incentives Almost always, manias are fanned by salespeople—whether they’re investment bankers, corporate executives, subprime loan brokers, or swindlers like Bernie Madoff. They profit from short-term fees, commissions, stock options, or the use of non- recourse leverage, which gives them the potential for large short-term gains with little risk.

5. A poor understanding of history and economics The time’s ripe for manias when businesspeople, government officials, and the general public have a poor understanding of economics or history—a poor understanding that makes them suspend belief or think that “this time is different.”

9 The bank’s willingness to fund speculators seems to increase exponentially if it has been a few years since the last boom-bust cycle. 10 Non-recourse means that the borrowers are not personally responsible for paying back the loans.

Why Are Manias a Problem?

So why are manias a problem? After all, a little irrational exuberance sounds like fun.

Manias are a problem because they’re like caffeine binges: After the boom comes the inevitable crash and associated headaches. People who invested hard-earned money are wiped out. Favored asset classes—railroads, office buildings, any form of heavy infrastructure—are overbuilt, the investment wasted on assets that will either never be used or will always be underutilized.

Creditors go unpaid—or more likely the government inflates the currency, making all of those who worked hard and saved and avoided speculation look like fools, and particularly hurting those on a fixed income. Seeing speculators make unearned profits—or even engage in outright fraud—while protected by the political class from their losses, weakens support for free markets and a free society.

How Do You Recognize a Mania?

How do you recognize a developing mania? Look for the following:

1. Excessive price-earnings ratios and other valuation metrics Price-earnings ratios, which measure the relative valuation of the equity of a publicly traded company, are a sure sign of a boom. Historically, the average value of a stock has been around 12 times earnings. Likewise, in a normal market, stable companies with defendable business models will trade around 5-7 times their free cash flows. When valuations are far in excess of these traditional norms, a bubble may be building.

For assets, you can also look at historical real (inflation-adjusted) prices. When valuations are far in excess of historical ranges—as with U.S. housing prices—a speculative bubble may be forming.

2. Financial yardsticks that are divorced from free cash flows Reliable financial measures like multiples of free cash flows and price-earnings ratios may get so inflated that new yardsticks that do not correspond to profits and free cash flows, —like price-to-revenues ratios, the “eyeballs” that visit a website, or “dollars per barrel” for oil in the ground—will become more common. Any time valuation metrics become divorced from free cash flows and other common-sense measurements, a mania may be brewing.

3. Recent financial trends confidently extrapolating far into the future Often manias are caused by unsophisticated investors extrapolating recent financial trends far into the future, with an air of certainty. Statements like “everyone should own stocks for the long run” or “housing prices always go up” or “everyone knows” that a certain outcome is inevitable, are reliable indicators of a mania.

4. Investors chasing after a “land rush” A flood of business plans that require companies to make large, risky upfront investments to capture “market share” or “first mover advantages” —rather than carefully identify and satisfy customers or buy assets with strong economic fundamentals—is a sign of an impending bubble.

5. Excess media coverage A proliferation of media coverage, and especially popular television shows that focus on the benefits of investing for small investors (particularly in new technologies or hot industries), fuel manias and bubbles. This is especially true when celebrities and other tastemakers are seen to be making “easy” money from speculative investments.

6. Industry insiders either in government or with powerful ties to government When industry insiders assume government roles—like the large number of former investment bankers (particularly from Goldman Sachs) who are currently serving in powerful government positions—or when insiders in hot industries like the subprime mortgage industry or alternative energy are heavily financing campaigns or offering special deals to regulators or members of Congress, it is a sign that unnatural forces are at work in markets.

7. Paper profits disconnected from physical reality Speculators can often inflate intangible assets more easily than tangible assets. Booms can start in industries with tangible assets like railroads, pipelines, and automobiles. But it is much easier to create “paper supply” and bamboozle investors when trading in intangible assets like stocks, complex mortgages, and derivatives, where value often depends on the wording of complex legal documents that few investors bother to read, and far fewer understand.

How Do You Profit from a Mania?

If you are a fundamental investor, you profit by selling early.

Manias are complex physiological and sociological events, triggered by people’s desire for a “heaven on earth” and their almost limitless capacity to fall for get-rich-quick schemes. While the astute entrepreneur can identify when you are in the middle of a full-fledged mania, it is almost impossible to predict when one will start or end.

So the first rule of profiting from a mania is to not lose money in one. In other words, be a committed contrarian, buy when market multiples are low and sell when they are high. This can be difficult, because it means you may have to sit on the sidelines for an extended time if valuations don’t make sense.

Rule two is to sell early. Once valuations reach what you believe are unsustainable levels, sell. There’s always plenty of liquidity—the ability to sell quickly—just before a market peaks. Once the peak happens, it is almost impossible to find buyers, meaning you have a long ride to the

8 bottom. There’s an old Wall Street adage: “Pigs get fat, hogs get slaughtered.” Take your profits when you can.

Fundamental investors continue to read histories and biographies to remind themselves that “this time isn’t different” and to insulate themselves from the siren songs of salespeople, journalists, politicians, and fools.

Look for “free options” and use non-recourse leverage with care. Free options are assets—like real estate or unused capacity—that might be valuable in a boom, but are thrown in along with a business or asset for free, if you buy during a slump. Non-recourse leverage allows you to buy an asset or company with little personal financial downside. But beware—if you default on such a loan, there can be protracted lawsuits and a negative impact on your reputation.

Summary

Manias and speculative booms are as old as markets. No one has shown a way—or even developed a reliable theory—to predict when such booms will begin or end. Predicting mob psychology or societal trends is just too difficult.

Being a careful student of history and economics, armed with an unemotional approach, historical valuation yardsticks, and a sensitivity to mania warning signs, can help you recognize when a speculative storm is brewing.

Being a contrarian is often a lonely role, because you have to debunk false hopes and dreams— or as Federal Reserve Chairman William Martin once put it, “Be willing to take away the punchbowl in the middle of the party.” Not a recipe for popularity.

The reward for such a clear-eyed and courageous approach, however, is avoiding being caught up in or wiped out by a speculative wave, and—through free options, the judicious use of non- recourse leverage, and selling early—possibly being able to profit from them.