A contributed perspective by Stephan J. Hess, CFP
Editor’s Note: This is another installment of a monthly series of contributed pieces addressing financial matters.
In 1637, a unique economic event occurred that disrupted financial markets. It wasn’t a famine or plague as you might suspect. No, it was a far more devious culprit, human greed. It started with a tulip of all things, and it created one of the largest economic bubbles the world has seen. That word, “bubble,” has been trending upwards recently given the staggering appreciation in both the stock market and real estate. What are bubbles and are we in one today? Let’s take a look.
Tulips became a thing in Europe in the 1630s. Having tulips meant that you were a person of status, so naturally everyone wanted them. Unfortunately, new tulip bulbs take time to develop so demand quickly exceeded supply, making them even harder to get. Scarcity in the marketplace usually gets resolved by a combination of increased pricing and the rapid expansion of supply until a new balance is found. If demand keeps outstripping supply, however, prices simply must go higher. The question is whether that demand is natural, meaning, are people buying tulips for their own use, or are speculators artificially creating that demand. We’ll get to that in a moment. The manufacturing, distribution, and sales of tulips exploded and so too did the breeding of highly prized tulip variations. Prices kept rising, and at the peak, the rarest of tulips commanded prices of a few hundred thousand in today’s dollars.
Capitalism fosters some of the greatest ingenuity the world has ever seen. The lure of financial gain motivates people and businesses to develop new industries that didn’t exist before. Investment dollars and loans fund the initial development and help to sustain the growth of those new markets. But capitalism can also run amok and be harmful, especially when investment and borrowing start to feed rampant speculation. As the prices and profits from tulips increased, everyone wanted in. People were no longer buying tulips for personal benefit; they were buying them to resell at higher prices. With more people willing to pay more, people gladly borrowed money to “flip” some tulips to the next person. This stage of a bubble always feels euphoric. Everyone is making money, and nobody is getting hurt.
All bubbles end the same way. Eventually they pop and the residue left behind looks nothing like what existed before. The seemingly limitless wealth creation that previously existed turns into a black hole, sucking in everything and anyone who happens to get too close. It happens in an instant and bubbles don’t preannounce when they are going to pop either. They just do.
There is a great story about JFK’s father, Joe Kennedy, who made significant money in the stock market in the “Roaring 20s” and got out before the crash. How did he know? The story goes that he stopped to get his shoes shined and the shoeshine boy gave him some stock tips. Mr. Kennedy somehow surmised that if everyone in society, even a lowly shoeshine boy, was investing in the stock market, how could it go higher if everyone were already in? Where would the next round of money and demand come from to push the markets higher? It was a brilliant observation. Personally, I had the same experience in 2007 when the person bagging my groceries was telling the cashier about the houses he was buying and flipping. Shortly thereafter, the mortgage crisis began.
At some point a bubble just runs its course. Prices of the underlying asset just get too high and the money funding that bubble dries up. Once people realize that there is no rescue operation coming, it is every man and woman for themselves. Everyone tries to sell at the same time and the lenders want their money back now. The engine that once roared to life seizes, goes cold, and the energy that once pushed it ever higher reverses direction. Demand for the tulips, or whatever the underlying asset is, crashes and it eventually reverts to a healthy and sustainable balance.
If you left the party early like Joe Kennedy, you did ok. Everyone else who stayed too late needs to deal with the massive hangover that’s coming. Those individuals and businesses that got greedy by investing all their money, or leveraging themselves with debt to buy even more, are going to be in a lot of pain. It generally causes bankruptcies, which can eventually become a drain on the whole economy.
Although the tulip bubble of 1637 was unique, asset bubbles are hardly rare. Let’s just look at the last 25 years. The mortgage crisis that I mentioned earlier turned into what we now call the Great Recession. It was fueled by low interest rates and an insatiable housing demand. People were flipping houses and buying as many properties as they could. People said that no more real estate was getting made so you better buy now. Kaboom!
The dot-com bubble developed in the same way, but with high-risk internet stocks as the underlying asset. It was all about clicks and eyeballs. Corporate revenues and profits were irrelevant, and people pushed valuations higher and higher. Companies with no revenues were worth more than Ford and Boeing. It was a brand-new economy they said. Kaboom!
Bubbles exist because we just can’t help ourselves. When the siren of easy money sings, it lures us in, and it doesn’t have to be stocks and real estate. literally any asset can catch fire. In 2008 oil shot up from $90 per barrel to $147 in about 6 months. There was no legitimate economic reason for oil to be that high, but speculators chased it there until it popped and crashed. In the late 90’s, the developer of Beanie Babies intentionally created artificial scarcity for his stuffed animals and a bubble was created. At the peak in 1999 some of the more rare animals were selling for thousands of dollars. A few weeks later you couldn’t give them away. Many people lost their life savings on those things trying to get rich. Kaboom!
So, are we in another economic bubble that is about to burst? There is no way to know that. But this is what I do know. Right now, margin debt is at an all-time high. Margin debt is the debt that allows you to borrow against your existing investments to buy more investments. Luckily today you are only allowed to borrow 50% of the value as compared to 90% in the 1920s. When it gets high it means that this extra pool of money and demand has already been tapped. Is this a good sign or a concerning sign? Another thing to consider is that online trading platforms like Robinhood, that cater to small investors, are taking off and most accounts there have the same limited number of stocks in them. Again, is this a good sign or a concerning sign? None of this means that something is imminent. As Warren Buffet says, “The market can behave irrationally, far longer than you think.” The key is to keep your head and not get sucked into whatever mania is taking over. Grab some popcorn and let’s see what happens.
Stephan J. Hess, CFP®, is a CERTIFIED FINANCIAL PLANNER Professional and is the owner of Hess Financial in Harrisonburg. Neither he nor his company has any financial relationship with The Citizen or its publishers.
