For centuries, children have enjoyed blowing bubbles. There is something enthralling in creating or witnessing a bubble as it grows, seemingly blissfully floats in the air, and ultimately pops. Sometimes, the anticipation of a bubble popping becomes too much for us, and we puncture it, ending its existence before its natural life span has run. Bubbles connote fun and frivolity; that is, if the bubbles of which you think are the type formed of a soapy liquid.
Bubbles, however, can also be very serious matters – evaporating fortunes and ruining lives. These more sober bubbles are economic and, in some cases, slimy rather than soapy in nature. An economic or market bubble occurs when speculation drives up the price of an asset far beyond its underlying value. Ultimately, the bubble bursts, and the value of that asset – whether a stock, bond, commodity, or other asset class – plummets. In economic bubbles, those with insider information frequently enrich themselves and divest, leaving the losses to be suffered by those less privileged.
Since the late ‘90′s, however, we have all learned a good deal about bursting bubbles. In the early days of the new millennium, the values of many of the so-called public “dot-com” companies plunged, some losing virtually all of their value. On March 10, 2000, the technology-laden NASDAQ Composite Index peaked at 5132.52 (intra-day). Just over two years later, it had plummeted to less than 20% of its peak value. In the eight intervening years, the Index has never even reached 3000.00. More recently, we have witnessed a plunge in real estate values as real estate bubbles have burst in communities throughout the United States.
Many people presume that economic bubbles are a recent phenomenon; perhaps, dating back to the U.S. stock market crash of 1929. These people would no doubt be surprised to learn that bursting economic bubbles are at least centuries old and, likely, much older. In one of the earliest recorded cases, an English enterprise, The South Sea Trading Company, gained exclusive trading rights with Spanish possessions in South America. These rights, however, presupposed a successful conclusion to the War of Spanish Succession (1701-1714) and, in conjunction with this effort, South Sea Trading acquired a good deal of English government debt incurred as a result of the conflict, with debt converted into shares of the then fledgling company.
The debt acquired provided the company a revenue source via annuity from the government of England. Additionally, close relations between the company and various government officials resulted in the company’s ability to establish and expand its price per share beyond the value of debt acquired. By 1719, South Sea had acquired more government debt and began a concerted public relations campaign touting its prospective income from trading activities with South America. During 1720, a speculative buying frenzy catapulted share prices from just over 100 pounds in January to more than 1,000 pounds in July. Share prices dropped precipitously that autumn when the “South Sea bubble” burst, never to rebound to the absurdly high levels of the summer months. At the time of the crash, many of the shareholders were peasants and common people who had risked what little funds they had saved on the chance at great wealth.
The period around 1720 in England, like the 1920′s and 1990′s in the U.S., was a period of wild stock speculation. In addition to South Sea Trading, countless other enterprises sought public capitalization, and like many of the dot-coms, took advantage of the ignorance of investors who, driven by greed and rising share prices, knew little or nothing about the companies in which they invested. Among the hot technologies seeking funding at that time was alchemy, with many such companies claiming the ability to change lead into gold or to produce an elixir that indefinitely extended life. Another company brazenly sought funding as a secret enterprise of “great advantage” to its investors.
There are many naive or stupid people who can easily become victims of fraud – witness the growth of phishing and other scams on the Internet. Whether based upon fraud or simply erroneous information, economic bubbles are fed by the investment of both knowledgeable and ignorant investors. When they burst, however, those left holding the bag are disproportionately those least able to bear the loss.
In investing, great rewards come only to those who bear great risks or possess uncommon knowledge – either in the form of unique insights or inside information. Lacking such resources or knowledge, one should take a page from childhood and delight in the simple pleasure of witnessing the buoyant and bursting bubbles.
