Speculative bubbles

Speculative bubbles (also referred to as market bubble or financial bubble) are maybe the worst nightmare for stock exchange. investor Probably you have already heard about the dot-com bubble in 2000, or real estate bubble someone is starting to suspect.

When a maket bubble bursts, the shares involved collapse, with large losses for investors. It is an interesting topic to be explored further: in this post we’ll talk about dot-com bubble, which has a number of interesting and perculiar aspects, that I think deserve to be highlighted.

But first, what’s exactly a speculative bubble? A speculative bubble (or, as we said, a market bubble) is a particular phase of a market, characterized by a substantial and unjustified increase in prices, due to a sudden growth in demand, and limited in time.

The excess of demand pushes the value of an asset (or a service, or a stock.. anything marketable, in other words) upward in a short time. This excess can be favored by an irrational exuberance of overly-optimistic investors, convinced that industry, product, technology (often, a new industry, product or technology) can offer massive profits and growth. Therefore there is a “race” to the purchase of the asset, hoping to resell it at an higher price. This race causes an increase in the price confirming, in the eyes of many, the goodness of the previous prediction of a future increase in the vaue, stimulating further purchases and therefore further increases of the price (we have some sort of self-fulfilling prophecy). The growth can become (for a limited time) so steady and massive that may draw attention of some investor usually reluctant to put money in the stock market, since they’re usually too risk-averse to be stock market investors.

But at a certain point, excess of purchase stops. There may be several reasoin: it may be difficult to find new investors willing to buy the assets at a price that in the meantime has become high; who bought the assets previously wants to sell them to monetize earnings; the previously optimistic outlook can be revised and downsized.

At this point, after the growth phase follows therefore an opposite phase, during which there is a decline in prices, which can be very fast (usually, faster than growth), also because of the awareness that, with less optimistic economic outlook, the values of assets are doomed to fall, and many investor want to sell them before a further decrease of price: the bubble burst.

I think it’s interesting to highlight a couple of aspects in market bubbles, and of the dot-com bubble burst:

  • The general collapse of stock exchanges in 2001 was not a result of September 11 attacks, as is often mistakenly believes. The decline, as can be seen from the graph of the MSCI World Index below, had begun much earlier, and it was mainly acused by increasingly widespread perception that the market was overvalued.
  • To me, the most interesting aspect of the internet bubble, however, is that many of the “new economy” companies, whose shares values skyroketed, not only did not produce profits, but had not even a real business model, i.e. they did not have a strategy on how to make money. There were several companies who perhaps had a website with a number of contacts, or just some idea for web services, (and this was enough to make their shares reach unbelievable price), but had not the slightest idea of how they could transform these contacts, these visits, in money: keep in mind that advertising had not yet widespreaded in the Internet. What many companies and investor seemed to have forgot, was that the fact people use a free service does not imply that a significant percentage of these people is willing to pay for it. Yet a large number of alleged experts came out even with formulas that bound the value of shares to number of contacts of its Internet site.
  • For these reasons, the collapse of the shares’ values was particularly “painful” for investor (several dot-com share price drop 99%; for example, Inktomi peaked $241 a share in 2000, and then was priced $1.63 in 2002, when Yahoo! buoght the company). May the suspected, or feared, “housing bubble” be like that? I think that a real estate “bubble” is deeply different: it is true that the real estate prices may be overvalued, but it is very, very unlikely that we suddenly notices that the buildings not worth anything, as happened for many dot-com companies. In the long period, it make sense that the building’s value keep growing, at least because the world population will increase (and therefore houses/offices/etc. demand) while the areas where you cannot increase that much. It’s worth noticing that this means that a 99% fall in house prices is unlikely, but this doesn’t mean it’s unlikely a price correction in next months (or years), on the contrary, a correction is, to me, inevitable since house prices have reached levels that many people cannot afford.

I leave you with a moral: always try to understand better than you can where you are putting your money, trying to understand how the sector works, how companies earn money, to understand if stocks are undervalued (and therefore they may increase value in the medium-long term) or overvalued (and therefore may decrease in value).

Italian translation of this post: Le bolle speculative

Banche e Risparmio []


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