An investment bubble refers to an event where a particular asset experiences a rapid increase in price, to a level where the price paid for the asset no longer bears any meaningful relation to its actual worth. What usually follows is a massive sell-off resulting in the so-called bubble bursting, mostly accompanied by major wealth destruction.
History abounds with examples from which we can not only gain insights into investment bubbles, but also take some guidance in terms of protecting ourselves as investors against the eventual disastrous consequences of such occurrences.
A ‘GET-RICH’ BINGE
Perhaps one of the most fascinating get-rich-quick binges in human history was the tulip bulb (yes, the flower!) craze in Holland. It all began in 1593 when a Viennese professor of botany imported a collection of unusual plants originating in Turkey. Over the next few decades, the flower became a popular, but expensive, addition to Dutch gardens. A non-fatal virus called ‘mosaic’ caused the flowers to develop coloured stripes called ‘flames’. These flowers were greatly treasured and public opinion dictated that the more bizarre the bulb was, the more it was worth.
Those who said prices couldn’t possibly go higher saw their friends make money while they missed out. Sound familiar? The temptation of buying a tulip bulb was hard to resist, and few Dutch did. In the last few years of the bubble, from around 1634 to 1637, people even bartered their personal belongings, such as land, jewellery and furniture, to obtain a precious bulb.
… WHICH ENDED IN TEARS
The story of course didn’t end well. As with all speculative crazes, prices escalated to a point where some decided to sell and take a profit. Others followed suit and the snowball kept growing until a tulip bulb was suddenly worth only a fraction of what it was before. What followed was a prolonged depression in Holland, sparing no one.
The Dutch weren’t the only victims of a get-rich binge in the 16th and 17th century. Just a few decades later in England, the stage was set for one of the most spectacular stock market bubbles ever. In fact, the term bubble originated during this period. Following a long period of British prosperity, savings were plentiful, but investment opportunities were hard to come by. Owning stock during this time was also considered something of a luxury, with only a few individuals benefiting from the success of the East India Company.
It’s within this context that the South Sea Company was created in 1711, with the initial purpose of helping to deleverage the British government by taking on some of its debt, which would be paid off by a stock offering to the general public. In exchange for taking on the government debt, the South Sea Company was given monopoly rights for all trade with the Spanish colonies in South America. The stock was held in high regard because of this, and demand was high. The only problem was that not a single director of the company had any knowledge of the South Sea trade.
By 1720, a speculative craze took flight and stock prices soared. Prices rose from £128 in January of that year to £1 050 in June. Even Sir Isaac Newton succumbed to greed, and eventually to gravity, losing nearly £20 000 on the stock. He famously said later: ‘I can calculate the motions of heavenly bodies, but not the madness of the people.’ To protect the public from further abuses, the government issued the Bubble Act, which banned companies from issuing stock certificates. This legislation was only revoked more than a century later.
THE MADNESS OF CROWDS
There are a few lessons to be learnt from these two stories. The first is that human emotion often dictates investment decisions. When prices are going up, most people become greedy and will engage in irrational activities, simply because of the potential to get very rich, very quickly. Of course, when prices fall, investor fear is likely to drive investment decisions.
The second lesson is that the fear of missing out while others become rich can be simply unbearable. It’s not fun to speak to your friends who made a lot of money on something you dismissed as a fad. And lastly, unsustainable prices may persist for years, making the sensible investor seem stupid not to participate. But if it is a bubble, prices will eventually revert to more moderate levels.
When looking at bubbles of the past we have the benefit of hindsight, making it is easy to point out the madness of the crowds. But what can prudent investors do to protect themselves from bubbles that may be forming in the markets today? Put differently, what clues can we look out for that might point towards the existence of a market bubble in our current investment climate?
In both stories, it’s clear that many people became greedy without necessarily attempting to understand what determines the value of a tulip bulb or of the South Sea Company. As a rule of thumb: when your Uber driver is speaking about his success in buying a certain stock, or any other asset, be cautious!
In addition, it’s not enough to just buy into a good idea, business or product. You need to take the price of the asset into account. Consider the internet companies of the early 2000s. Many had fantastic ideas and some were in fact successful (think Amazon or Google), but the prices paid for them were simply not justified given their level of earnings.
CRYPTOCURRENCIES AND TECH STOCKS
Would we consider cryptocurrencies such as bitcoin to be in bubble territory? They certainly meet the criteria set out above – they’re very popular, but few really know how they work. They may well be a good idea and change the world as we know it. However, since it’s hardly possible to value them using conventional methods, buying them would largely reflect the hope that someone else will in future be prepared to pay a higher price. The likelihood of overpaying under these circumstances is high and we would therefore apply extreme caution when dealing with cryptocurrencies.
What about technology stocks such as Tencent? Although we view the company as being expensive, we don’t believe it’s an investment bubble. Unlike the South Sea Company or the Dutch tulip, Tencent is a high-quality business growing its earnings materially above average rates.
However, as we’ve said, it’s not enough to simply invest in a good business – the price paid for it must also be taken into account. Tencent is currently trading at a forward price-earnings (P/E) ratio of about 40, which is still well below the P/E ratios at which technology stocks traded during the dot-com bubble (in 2000, the NASDAQ 100 Index traded above 100 times earnings). We therefore think that this stock, although expensive, still has upside and is not yet in bubble territory.
