Bubbles Then and Now - October 31, 2006

When I was young I used to spend hours blowing bubbles. I would watch them rise into the air, chase them and cause them to burst. Ten cents at the five-and-dime would buy a bottle of soapy water and a gizmo that you dipped into the bottle and blew into or waved in the air to create the round floating objects. Back then, I thought bubbles were a lot of fun. It was only when I grew much older that I learned that bubbles weren’t fun for most adults. Of course, I am referring to investment bubbles.

Investment bubbles have probably occurred ever since money was invented. They are not unique to any one country or any particular commodity. In the 1630's, tulip bulb mania struck Holland. The Mississippi Scheme swept across France in 1719 and 1720. The South Sea Bubble began with speculation in the South Sea Company in England at about the same time.

In the United States, rampant speculation sent stock prices skyward in the 1920's. The Dow Jones Industrial Average, which traded at 95.52 at year-end of 1923, expanded to a high of 381.17 in early September 1929. That bubble burst in the great stock market crash in October 1929. By early July 1932, the Dow Jones Industrial Average had retreated to a mere 41.22, a deflation of slightly more than 89 percent.

After Japanese stock prices rose continuously during the 1980's, bewildered investors could not fathom how Japan's Nikkei 225 could have been valued 91 percent higher at the beginning of 1990 than it was just nine months later. The same could be said about the Dow Jones Industrial Average’s 508-point plunge on October 19, 1987.

More recently, the so-called "dot com" bubble burst in mid-2000 and so did the dreams of countless investors who believed that their retirement years would be spent in splendor not imagined ten years earlier. The technology stock laden Nasdaq Index soared above the 5000 level in early 2000. Three years later, investor dreams of affluence and retirement utopia evaporated when that Index was trading at a mere 20 percent of its value in early 2000.

The pain caused by the dot com bubble was severe. However, a year later investors were again caught up in a growing bubble that would burst in 2006. During the course of a five-year real estate bubble, the prices of single family homes in many parts of the country expanded by an average of 300 percent or more. I was told by a number of amateur real estate speculators that it was folly to invest in the stock market, which historically has produced low double-digit average annual returns, when one could earn triple-digit annual returns investing in residential real estate. Because of the extreme leverage in the real estate market (investors need only commit capital equal to 5, 10, or 20 percent of the value of the property), a 30 percent appreciation in price translates into returns ranging from 50 to 500 percent.

Once again, investor dreams of instant riches were shattered when this bubble began to leak air earlier this year. In many parts of the country, the inventory of homes for sale has expanded from one or two times monthly closings to 9 to 12 times monthly closings. As you might expect, home prices have started to decline. In Naples Florida, for example, several properties recently sold at auction for prices 20 to 40 percent below the prices paid in 2005. And the situation could get worse before it gets better. Real estate speculators are now experiencing the negative impact of leverage. Put down 20 percent in equity to buy a property and a decline in value of 20 percent will result in a 100 percent investment loss.

I am not sure of the root causes of investment bubbles. Certainly greed plays a role. The prospect of big returns during short periods gradually lures more and more investors who continually inflate prices. At some point demand wanes and the bubble begins to deflate. A rush of investors to the exits causes the bubble to burst. There are several things I do know about investment bubbles. First, when an investment bubble bursts, it's rarely fun. Second, any investment that promises excessive returns is accompanied by excessive risk. Third, no matter how long they last, investment bubbles eventually burst. Fourth, like bubbles made of soap and water, when investment bubbles burst, your money instantaneously disappears into thin air. Finally, although it is possible to make money when an investment bubble begins to expand, those around at the end usually lose most if not all they have invested.

It is not possible to sidestep investment bubbles. If all of us did, speculative fever would be muted and bubbles would cease to exist. However, savvy investors know that there are two questions which must be answered before undertaking any investment: what is the return and what is the risk? If you spot investment returns that are too good to be true, you have most likely spotted the next investment bubble that will expand and eventually burst.

Dr. Gerald W. Perritt