Money and Banking Economic Bubbles: Analysis, Predictability and Aftermath Currier and Ives, 1875. Executive MBA Professor: Jean-Claude Oswald Author: Constant Gbaguidi August 2006 Date Page EMBA_Bubbles_060810 10. August 2006 1 of 22 Table of contents 1. Introduction 3 2. Analysis of Bubbles 4 2.1. Some Famous Bubbles 4 2.1.1. Tulipmania (1637) 4 2.1.2. Poseidon (1969) 4 2.1.3. Beanie Babies (1996) 4 2.1.4. The Internet Bubble (2000) 4 2.2. Basics 5 2.3. Bubble Cycle 7 2.3.1. Inflation 8 2.3.2. Rise Over Fundamental Value 9 2.3.3. Market Mood and Communication 14 3. Bubble Predictability 17 4. Bubble Aftermath 18 4.1. Similarities between the Internet Bubble and the Great Depression 18 4.2. De-bubbling 18 4.3. Bubble Virtues and Vices 19 5. Conclusion 21 6. References 21 Date Page EMBA_Bubbles_060810 10. August 2006 2 of 22 1. Introduction The business cycle is made up of periods of expansion and contraction. Sharp expansion is called bull and sharp contraction is called bear. This is a normal wealth creation process, in the first place. However, history has witnessed many occurrences of abnormal expansions, with three-digit growth rates on a given market: the appropriate term to qualify such a state is ll u economic bubble. Consider B what happened to Ababacar Diop in 2000 [13]: he was paid Be €4,000,000 to give up the a domain name vizzavi.fr that he rr had bought earlier for a couple of hundred euros. Such an event happens in many markets every year but many such events happened between 1996 and 2000. Asset prices increased without any real value creation: this is the main characteristic of a bubble. Figure 1Illustration of bear and bull. An economic bubble refers to a market condition where the prices of commodities or asset classes increase to absurd levels that no longer reflect utility of usage and purchasing power. Bubbles indicate an abnormal market situation that challenges the market equilibrium concept. The purpose of this document is to analyze the advent of bubbles, investigate into ways to predict them and review the aftermath. Date Page EMBA_Bubbles_060810 10. August 2006 3 of 22 2. Analysis of Bubbles Before analysing the mechanisms that lead to a bubble, it is worth describing some of them. 2.1. Some Famous Bubbles 2.1.1. Tulipmania (1637) Tulipmania is the first inventoried bubble [6]. Tulip, grown in the Netherlands as from around 1593, had rapidly become a luxury item and a status symbol. In 1623, a single bulb of a renowned tulip breed was worth up to 1,000 Dutch florins (the average yearly income at that time was 150 florins). In 1635, a record showed 40 bulbs sold at 100,000 Dutch florins – a single bulb was then worth 2,500 florins. In 1636, tulips started being traded on stock exchanges with non-regulated tulip futures contracts. In February 1637, the demand dropped and the traders began selling the tulips. The traders were left with their futures contracts to be honoured. 2.1.2. Poseidon (1969) In the late 1960s, nickel was in high demand due to the Vietnam War, but there was a shortage of supply due to industrial action against the major Canadian supplier Inco [5]. These factors pushed the price of nickel to record levels, peaking at around £7,000 on the London market early in November 1969. In September 1969, the mining company Poseidon NL made a major nickel discovery at Windarra in the Shire of Laverton, Western Australia. In early September Poseidon shares had been trading at $0.80, but as information about the discovery was released, the price rose up to $12.30 on October 1. After this, very little further information came to light, but the price continued to climb due to speculation; at one point, a UK broker suggested a value of up to $382 a share. As the price of mining shares grew, numerous new companies were listed by promoters looking to cash in. Some of these new listings did not even have any mining leases. As the new companies started crashing, the image of mining stocks was tainted, and the prices began to fall. 2.1.3. Beanie Babies (1996) Beanie Babies are stuffed animals filled with plastic pellets. They were created as from 1993 by Ty Inc. Hundreds of different models had been created, including specials like for July 4th or Lady Di. The success of Beanie babies created faddish craze of collecting. Ty Inc. encouraged the fad by retiring many models and ceasing the production of those. The collectors’ expectation of a price rise never happened to the extent initially thought of. 2.1.4. The Internet Bubble (2000) The Internet started to attract business interest in 1995. This was a breakthrough technology that was lowering all entry barriers, by increasing the bargaining power of the buyer ( a quick search on the Internet could help compare prices offered by different sellers), and reducing the start-off capital for many businesses, mainly by bypassing intermediaries, especially in the promotion and distribution of one’s product. Although they were right about the breakthrough era that the Internet was announcing, many investors overvalued the potential of the technology. Like for any emerging technology, Internet specialists were rare at that time. In order to attract those rare resources, Date Page EMBA_Bubbles_060810 10. August 2006 4 of 22 companies had to offer stock options and very good working conditions. The wealth effect was at its top, creating inflation everywhere. The NASDAQ was at its top as well, around 5,100 index points. The fear for the millennium turn in 2000 was probably a major factor that sustained the bubble. Many companies were paying a large amount of money to alleviate any potential harm from the 2000-bug. That bug never occurred and the turn of the millennium happened without any major information technology breakdown. As a consequence, the perspective for IT spending decreased and might have played a role in the crash of the Internet bubble in 2000. Also, anti-trust accusations against Microsoft and the threat of a split of that IT giant into pieces (as happened with AT&T in the 1980s) put doubt into investors’ mind. The crash happened on March 10th, 2000, as illustrated in the below chart. Figure 2. The NASDAQ Bubble [10]. As reported by Bambi Francesco of MarketWatch [12], 76% of venture funding invested over the past 27 years occurred in 1999 and 2001, citing a Morgan Stanley report. Many companies that were funded might not have been. 2.2. Basics The painting by Currier and Ives (1875) as reproduced on the front page of this document (and in the below figure) gives a very good illustration of the perception of bubbles by a rational person: bubbles are based on expectations (whether rational, realistic or not) and are a good way to “grow poor”, whereas hard work is the guarantee for growing rich. Indeed, bubble-generating ventures are comparable to gambling (forecasting and goodwill: nothing tangible). Hard work is an asset that is valued on the basis of economics and finance fundamentals. Date Page EMBA_Bubbles_060810 10. August 2006 5 of 22 Assets ExExpectations Assets FoForecrecasting, potententialtial growthowth,, FFundaundamenmentalstals (e..gg., bbooook vallue,ue, marmarkket value:value: ggooododwwiillll, gamblingamblingg prpricicee to earnearnings,ings, assasseet ratio, ccapitalapital ststrrucucttureure)) Figure 3. Expectations vs. assets: the roots of economic bubbles. There are different types of economic bubbles: Bubble Stock Market Bubble Financial Bubble Commodity Bubble Real Estate Bubble e.g.e.g.,, IntInteernrnet bubbblble inin e.g.e.g., crcredieditt cruunncchh ofof e.e.g.g.,, ttulipulipmaninia,a, 19919988-20020000 1966,66, andand 1920920s bubbubblble bbeaeanniiee babiabies,es, stampamp collcollecectingting, ongoigoinng oil anandd gogoldld bubbbblleess Figure 4. Classification of bubbles. • Stock market bubbles are bubbles that originate from the stock market. An example is the Internet bubble of 2000; • Financial bubbles mainly affect the banking system. Examples are the credit crunch of 1966 and the 1920s bubble that eventually led to the Great Depression. Indeed, in the 1920s, banks kept lending to companies in construction, radio and automobile but, due to restrictive international trade laws, Date Page EMBA_Bubbles_060810 10. August 2006 6 of 22 companies could not sell their products, leading to an oversupply situation and to deflation. As the deflation lasted, it became a depression that affected the entire world; • Commodity bubbles are the like of the tulipmania of 1637 or the oil bubble that starting in August 2005; • Real estate bubbles relate to bubbles affecting the real estate sector. 2.3. Bubble Cycle Bubbles always start with a real event that has nothing to do with irrational thinking. That event could be a new technology, the expansion into a new market and the overvaluation of the potential thereof, a new product, a political event, a new fashionable trend, or a sudden increase in the demand for a product. That real fact would trigger an irrational exuberance that would lead to a bubble. The burst of the exuberance can be intentionally triggered by governments (de-bubbling) or result into a crash. 3. CrashCrash 1. EvEventent 2.2. IrraIrrationtionalal exuberanceerance 4. De-bubbubblinblingg -NNeew tteechnonollogyogy -Inflation (low iinntteerest ratete) -New markerkett -SSppececuulalatitionon -NNeew prododucuct -Biases -Polliittiical evevenent (e.g., -WeWealalth eeffffeecctt -Government intterervententioionn (interest wawarr,, eellecectitiononss)) -SSiiddee efffects:ects: bbuubbbblesles inin otherher rate, ffiiscascall ppololicy) -NNeew ttrrendend markets, especiallly rreeaall estateestate -Increase in need fofor a pprroducoduct -… Figure 5. The Bubble cycle. The main causes and manifestations of irrational exuberance are inflation, absurd rises over the fundamental value of assets, and critical market states influenced by communication.