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Bubbles, Busts, Fads and Manias

Wall Street Always Falls In Love with the Next Big Thing

“We covet what we see,” Dr. Hannibal Lector said to Agent Clarise Starling in the movie Silence of the Lambs. Okay, so Hannibal the Cannibal is probably not the go to source on human behavior, but the observation is on point nonetheless; desire is stoked by the senses, especially sight.

The human brain is a marvelous machine, as it can take a visual stimulus, attach a feeling to that stimulus, and imbed that feeling into the viewer’s memory so that they want/need to experience that feeling repeatedly. Said stimulus could be fashion, jewelry, cars, real estate, you name it. This is the genesis of a fad, and human beings have always been susceptible to fads.

Investors appear particularly defenseless against the rage de jour, so much so that a mere fad can morph into a mania. A mania is a speculative frenzy of buying in a specific asset or market segment, not because of the fundamental value of the asset, but in the belief the market value of the asset will rise forever, which means it can be sold repeatedly at a greater price.

There are a lot of examples throughout history, but one in particular stands out. In the 1960’s and 1970’s there were a collection of growth stocks that were referred to as the Nifty Fifty. There was never an actual list of fifty stocks, but these were primarily large-growth companies with consistent earnings increases that many considered one-decision stocks. Investors could supposedly buy them and never sell, despite high valuations. You know, companies like Eastman Kodak, Sears Roebuck & Co., Polaroid, and Xerox. Sure, there were others, household names still around in fact, but as a group they fell about 58% between 1973 and 1975.  

In 1987 “portfolio insurance” was the cure to downside price risk. Using computer algorithms to construct hedges of derivatives, basically buying stock index futures in rising markets and selling them in falling markets, portfolio insurance was supposed to protect investors from large downside moves. So, how did that work out? Only in the largest one day stock market percentage decline in history. 

High-yield or “junk” bonds had their day in the sun, especially when taking companies private to “unlock” shareholder value. You know, the leveraged buyout craze. 

Hmm, the Japanese Real Estate and Stock Market Boom/Bust was a doozy. Bandwidth, shimmering seas of bandwidth (see Dot-com/Tech Wreck below).  

Credit Default Swaps (CDS), Collateralized Debt Obligations (CDO’s), and Collateralized Mortgage Obligations (CMO’s). Strange isn’t it how algorithms and derivatives keep popping up? 

The Cloud, everything became about The Cloud, and The Internet of Things. Now all of these “Cloud” companies have turned into “AI” companies. Yes sir, Artificial Intelligence, that’s the hot ticket. I can’t wait to see how that turns out. 

We hear the term “bubble” a lot. Fun fact, the term bubble came about with the passage of the “Bubble Act” in 1720 by the British Parliament. England was carrying a large amount of war debt, which the Parliament exchanged for exclusive trading rights in the gold and silver rich South American colonies to the South Sea Company. Investors, sensing an opportunity to replicate the success of the East India Company quickly inflated the share prices of South Sea, which the Act sought to curb. Subsequently shares in South Sea declined from 950 British pounds to 290 between August 31 to October 1, 1720.  

Today it seems when any segment of the economy has become extended it is referred to as a bubble. I mean seriously, read a book, you know? 

What financial academics call a “credit dislocation,” in less elitist language is an asset bubble burst. In truth there are really just a handful of such blow-ups:  

The Dutch Tulip Bubble - Tulips were introduced into Europe shortly after 1550, and became widely popular because of their beauty and as a status symbol. The demand for varieties of different colors and scarcity eventually exceeded supply, and prices for these rare bulbs began to rise at a rapid pace in northern Europe. Prior to 1633 Holland’s tulip trade had been restricted to only professionals and experts, but the lure of steadily rising prices encouraged many ordinary middle-class and poor families to speculate in the tulip market. Homes, estates, and industries were leveraged so that bulbs could be bought for resale at higher prices. Sales and resales were made many times over without the bulbs ever leaving the ground, and rare varieties of bulbs sold for multiples of the equivalent of annual wages. The crash came early in 1637 when price increases became insufficient to cover borrowers costs, and almost overnight the price structure for tulips collapsed almost 99%, sweeping away fortunes and leaving behind financial ruin for many ordinary Dutch families.  

The South Sea Bubble - The South Sea Company was promised a monopoly on all trade with the Spanish colonies of South America by the British Parliament when it was formed in 1711. Hoping for a repeat of the success of the East India Company, which provided England a flourishing trade with India, investors snapped up shares of the South Sea Company. As tall tales of unimaginable riches in the South Seas (present-day South America) circulated, shares of the company surged from £125 in January to £950 in August, before collapsing and causing a severe economic crisis. 

The Crash of 1929 – The Roaring Twenties, doesn’t the name catch it all? The New York Stock Exchange was the venue where the Dow Jones Industrial Average roared from 63 in August 1921 to 381 in September 1929. On Black Monday, October 28, 1929, the Dow declined nearly 13 percent. On the following day, Black Tuesday, the market dropped nearly 12 percent. By mid-November, the Dow had lost almost half of its value. The slide continued through the summer of 1932, when the Dow closed at 41.22, its lowest value of the twentieth century, 89 percent below its peak. The Dow did not return to its pre-crash heights until November 1954.

The Dot-Com Crash/Tech Wreck – The 1990’s were an incredible period of growth and innovation due to the rise of the Internet. “The New Economy” was all the rage and businesses or mere concepts of businesses that were drawn up on cocktail napkins achieved multi-billion dollar valuations as soon as they went public, even though many had never made a dime in revenues or would make a dime in revenues. The NASDAQ Composite Index, where the majority of technology/dot-com stocks were traded, rose from about 750 in early 1990 to over 5,000 at its peak in March 2000. What followed was a breath taking plunge as the Index crashed and burned about 80% by October 2002, which triggered a U.S. recession. The next time the Index reached a new high was in 2015, more than 15 years after its previous peak.

The Great Recession – Due to the staggering amount of capital being wiped out in the Dot-Com/Tech Wreck, and with the U.S. mired in a deep recession, investors and Wall Street were desperate for liquidity. The Fed slashed interest rates to stimulate the economy, and because the U.S. housing market had been on an absolute tear since 1996, homeowners discovered they had vast amounts of home equity. With the ability to tap into that equity and refinance at a rate less than their current rate, homeowners could buy second homes, RV’s, boats, planes, whatever, and still have money left over to put into the stock market. Income investors, however, who could no longer find sufficient yield in U.S. Treasury bonds, turned to mortgage-backed bonds due to their higher yield, and safety because hey, the U.S. housing market was dependable, right? With a greater demand for mortgage backed bonds, Wall Street needed buyers to take out mortgages so they could package them into bonds. With much of the nation still emerging from a deep recession, however, qualified borrowers were not plentiful. No problem, of course you qualify! There are all kinds of new mortgages. You can fog a mirror can’t you? All good things, of course, have to come to an end and from 2004 through 2006 the Fed had to raise interest rates to control inflation. With interest rates rising the rates on existing adjustable mortgages began to reset higher and faster to rates beyond what borrowers expected or were able to pay, and because prices had stopped rising they were unable to refinance. This led to selling, and eventually to massive numbers of foreclosures, which increased the supply of homes to the point where it led to what became known as the great housing bust.

But wait, there’s more! Neither the Fed nor the White House had clued into how much the banks, hedge funds, and brokerage firms, which sold mortgage backed securities to each other, had become dependent on derivatives such as CDS’s, CDO’s, and CMO’s. Derivatives, by the way, are contracts whose value is derived from another asset, and that theoretically insured against the risk of default.  

Cutting to the chase, banks sold way more, how can I say, exotic, mortgage-backed securities than good mortgages, but justified these excesses because of the aforementioned credit default swaps (CDS), which, like portfolio insurance in 1987, was supposed to protect against downside risk, in this case defaults. Unfortunately, the mortgage backed securities market caved in, and the insurers did not have the capital to cover the CDS holders. 

What followed was seemingly a spiral of destruction with the collapse of Lehman Brothers and Bear Stearns. American International Group was saved by the federal government. Fannie Mae and Freddie Mac Bank were taken into conservatorship. Merryll Lynch was acquired by Bank of America. Many other banks were acquired by the likes of JP Morgan Chase. 

On Sept. 29, 2008, the stock market crashed. The Dow Jones Industrial Average fell 777.68 points in intra-day trading. Until 2018, it was the largest point drop in history. 

On Oct. 3, 2008, Congress established the Troubled Asset Relief Program, which allowed the U.S. Treasury to bail out troubled banks. The Treasury Secretary lent $115 billion to banks by purchasing preferred stock. The Federal Deposit Insurance Corporation limit for bank deposits was increased to $250,000 per account and allowed the FDIC to tap federal funds as needed through 2009. That reduced the fear that the agency could possibly go bankrupt.

On Feb. 17, 2009, Congress passed the $787 billion economic stimulus plan called the American Recovery and Reinvestment Act. The Act granted $212 billion in tax cuts and $575 billion in outlays, including $311 billion for new projects such as health care, education, and infrastructure initiatives. 

On March 9, 2009, the Dow finally hit its bottom at 6,547.05, which represented a decline of 53.8% from its peak close of 14,164.53 on Oct. 9, 2007. This was worse than any other bear market since the Great Depression of 1929.  

I could write more about the Great Recession, but suffice it to say that its effects lingered on with the advent of the most radical monetary policy ever in the form of Quantitative Easing (QE). The result of that policy produced the most overvalued conditions in the stock market ever, including 1929 and 2000. Let that sink in for a minute. 

As I have written many times, human nature has changed very little since the Garden of Eden. Fear and greed are still the two most powerful human emotions. As such, the lure of vast riches and quick profits has been at the root of most of the bubbles, busts, fads, and manias throughout investment history. The majority of successful investors have understood that investing is a business and should be treated as such. If you want to gamble go to Vegas. At least you can eat well and enjoy and good show.  

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