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 Copyright 2014 by the Acton School of Business. No part of this publication may be reproduced, stored in retrieval system, or transmitted in any form or by any means without the written permission of Acton School of Business. This curriculum is used in its entirety at the Acton School of Business, based in Austin, Texas, an intense one year program taught exclusively by successful entrepreneurs. To learn more, visit www.actonmba.org. 08/2014 $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. 2 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. 3 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. 4 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.

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