April 6 2010|07.06 AM UTC

Stan Reybern

12 Painful Lessons Learned From Bubbles of the Past

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Classical economists have long described human beings as “rational actors.” By this, economists mean that most people try to achieve their best interest by intelligently weighing the pros and cons of their choices, seeking evidence, and behaving in a collected manner. No greater evidence exists to the contrary, however, than market bubbles. While humans are certainly more rational than lower species, the history books are filled (indeed, still being filled) with soaring market activity caused by little more than hype and speculative mania. What makes these bubbles consequential, of course, is that they eventually burst – often with painful consequences. Furthermore, these consequences affect even those who played no role whatsoever in the buildup of the bubble. That makes bubbles a subject worthy of study by us all. Today, Billshrink dissects 12 painful lessons learned from bubbles of the past, including the early to mid 2000′s housing boom.

Be Skeptical of Groupthink

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It takes one’s breath away to discover how many bubbles were driven by little more than widespread beliefs left unquestioned until it was too late. The late 1990′s tech bubble, for example, saw an unprecedented number of profitless companies go public. Even companies with no clear business model managed to sell stock to the public on the strength of merely being an “Internet company.” Indeed, as journalists sometimes joked about at the time, simply affixing an “e” to the beginning of a company’s name was often enough to raise its stock price. The driving force behind all of this was the fuzzy belief that “the Internet”, as such, would bestow profitability upon any company involved with it. How has the fervent belief, held by many in the late 1990′s, in tech and growth stocks held up in the decade since? As USA Today reported in a March 2010 article on market bubbles, large companies in growth mode have “been the worst place to be among the major classes of stock since then, with the Wilshire US Large-Cap Growth index falling 34.3%” In short, do not assume that millions of investors cannot be wrong, because they frequently have been.

Do Not Trust The Media

As they did during the tech bubble, various media personalities contributed to the hysteria leading up to the late 2000′s housing bust. Arguably the most famous example is Mad Money host Jim Cramer, who enthusiastically reassured viewers that it was smart to invest in AIG despite that firm’s heavy concentration of credit-default swaps. Cramer also saw no problem advising viewers to invest in Bear Stearns, which subsequently collapsed not long after. In a memorable interview on Comedy Central’s The Daily Show, Cramer was was taken to task by Jon Stewart for the carelessness with which he dispensed advice that was in keeping with the prevailing bubble dogma of the time. Billshrink discussed Cramer and other media gurus in 2009′s “Hall of Shame: 12 of the Worst Financial Gurus” article. Its main point, and the point that matters presently, is that the media’s quest for ratings often runs astray from your own investment objectives. True financial experts (like Warren Buffet) have suggested, for instance, that most investors would be best off investing in passive, low-cost, broad-based index funds. Cramer and his ilk rarely discuss that and often espouse the very behaviors that turn out to have helped cause bubbles.

Be Wary of Breaking From Tradition

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For all that can be said of innovation, it has frequently been the most innovative practices and behaviors that ultimately turned out to have caused bubbles. The recent housing mania is a case in point. Many of us are aware of the role that no down payment mortgages, subprime mortgages, and other exotic financing instruments played in the record rise in nationwide home prices. Some mortgages not only required no down payment, but also increased the payment at six to twelve month intervals over several years before the final, full mortgage payment amount took effect. Such financing techniques, though, were far from normal in that business. In his penetrating book The Housing Boom and Bust, economist Thomas Sowell quotes a long-time bank officer who said that home lending was once one of the most stable businesses in the country. When banks made 30 year, fixed-rate, self-amortizing mortgages to borrowers who put 20% or more down, default rates were relatively low and predictable. Once the lending practices changed, so, drastically, did the outcome. The lesson here is to consider carefully why traditional ways of doing things have stood the test of time before sweepingly brushing them aside for untested methods that more fashionable at present.

Be Skeptical of Politicians

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While politicians are eager to deflect blame for bubbles onto private businesses, they are far from blameless in America’s biggest market manias. In The Housing Boom and Bust, Sowell exposes the rarely discussed role that laws like the Community Reinvestment Act played in that bubble. Over time, politicians used CRA to literally force banks to prove they were lending to a politically acceptable number of minority and low-income borrowers. These quotas were based not on sound lending practice as dictated by decades of experience, but by what various regulators with neither experience nor expertise in lending preferred. Furthermore, failure to meet those quotas triggered consequences ranging from Department of Justice investigations to being denied tax breaks or regulatory permission to do things that non-banks did not need permission to do. Scholars of the Great Depression have pointed out the role of the Federal Reserve in that bubble. Sowell, for his part, argues that government intervention prolonged and worsened the Depression. Unemployment peaked at 9% two months after the October 1929 crash, and then trended downward to 6.3% by June 1930. Then Congress passed the Smoot-Hawley tarrifs (among other laws) to “accelerate” the recovery. But by November 1930, unemployment had risen to 11.6% and did not fall below double digits again for the entire decade of the 1930′s. In other words, the market appeared to be correcting itself before Smoot-Hawley and the New Deal was passed, after which the economy did not improve, but in fact got much worse.

Seek Evidence, Not Consensus

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As noted, many bubbles are caused by misinformed groupthink and consensus. There is a tendency in human nature to mimic the opinions and beliefs of others because, after all, how could so many people be wrong? Unfortunately, consensus is seldom the best way to determine the truth. John T. Reed, a Harvard MBA and real estate investment expert, sums up the problem with relying on consensus in his article on global warming:

“Over the years, the consensus said that the earth was flat, the universe revolved around the earth, trauma caused cancer, leeches would make you healthy by removing bad blood, Pluto was a planet, minorities and Jews were inferior, etc. Basically, the consensus has a poor track record and a bad reputation.”

All kinds of invalid defenses are used to justify consensuses, from circular logic (“it’s true because all the experts say so”) to arguments from intimidation (“only an idiot would actually question this belief.”) However, it is important to remember – especially when it comes to bubbles – that consensus and truth are not one and the same. Those who challenged with facts and logic why they should stake their net worth on profitless tech stocks fared better in the early 2000′s than those who meekly accepted pop-investment dogma. Ditto for those who consulted their checkbooks before agreeing to mortgage payments that consumed 80% of their take-home pay.

Bubbles Can Conceal True Winners

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Another interesting fact brought to light by USA Today in their March 2010 article was that “back when big tech stocks were popular, small and mid-size companies paying dividends were practically forgotten.” And despite how real estate investment trusts (or REITs) were “the anti-bubble stock” of the mid-late 1990′s, USA Today reports that “the Wilshire US REIT index is up 201.4% since the 2000 peak, and the Wilshire US Small-Cap Value index is up 145.6%.” The explanation here is simple. In the herd’s zeal to participate in the latest market mania, all kinds of sensible, profitable and less risky investments are utterly overlooked. Happily, this creates opportunities for truculently realistic investors who can see through the hype to the deals others are passing up.

“Be Greedy When Others Are Fearful”

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A sad fact of bubbles is that the aftermath affects even those who played no role in its creation. Passive investors or workers with pension funds, for example, typically do not pick individual stocks or chase market fads but instead invest uniformly across the broad market spectrum. Those people are nevertheless hurt when the market tanks as the result of a burst bubble unrelated to their own behavior. That makes it important to invest effectively after a bubble bursts, not just before and as it is building. One principle, espoused by Warren Buffet, is to “be greedy when others are fearful.” When a bubble bursts, investors tend to act quite irrationally in their valuation of corporate stocks. In late 2008, for example, perfectly healthy companies saw their stock prices fall lower than the amount of liquid cash those companies had on hand. Investors whose positions were not devastated by the bubble in question are often wise to purchase such stocks, which are bound to rise in value after the burst-induced paranoia fades away.

No Bubble is the Last

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Another all-too-human tendency (especially among those experiencing their first bubble or bust) is to imagine that markets are “usually” free of such things, and that the one currently taking place is just a freak occurrence like snowfall in May. Eager to play into this sentiment, politicians subsequently promise to “enact reforms” that will “ensure this never happens again.” Regardless of these beliefs and promises, however, bubbles are a fact of life. Market economies follow boom and bust cycles as naturally as tides go in and out and humans wake up and fall asleep. True, some are worse than others, and how they are dealt with can shorten or prolong them. But the fact remains that not every year can be an up year for the entire market. Therefore, do not assume that any given bubble is the last or that sweeping political changes will necessarily prevent one from occurring in the future.

Educate Yourself

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Perhaps the best lesson (and the one most regularly ignored) to be drawn from any bubble is to educate yourself. In broad terms, this encompasses studying books, lectures, or articles on such subjects as law, markets, economics, business and psychology. The reason it is important to educate yourself is that market forces are acting upon us at all times. Knowledge empowers you to respond, at least in part. Furthermore, these forces are not categorically “good” or bad” – they simply “are.” as Fortune editor Allan Sloan writes in a piece for the Washington Post:

“The market wasn’t benign during the bull market years, and it’s not malignant now. It’s just the market. It takes care of itself. And you’d better take care of yourself by living below your means, doing your homework, and being careful and skeptical.”

Furthermore, it pays to educate yourself on these subjects using hype-free, no-nonsense sources before a bubble hits, when most information tends to be tainted by political spin or media melodrama.

It Takes Two

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An oft-overlooked aspect of most bubbles is that there are two parties (at minimum) to every economic transaction. From this rather obvious fact, it follows that the recessions which accompany the bursting of a bubble are not categorically “bad” for everyone in the economy. The media, for example, has portrayed the current late 2000′s recession as being a nationwide disaster for just about everybody. In actuality, it is most disastrous for foreclosed-upon home owners, much of the U.S. automotive sector, much of the U.S. financial sector, and the like. It has been far from a disaster for bank foreclosure departments, estate auctioneers, debt consolidation houses, regulatory agencies and other counter-cyclical groups which prosper in direct proportion to the bubble’s fallout. Some sectors (including many Internet businesses) have scarcely been affected by the recession at all. Many articles have been written also about the life-changing inventions (such as nylon) that emerged during the Great Depression. The lesson to absorb is that recessions and bubbles are not “good” or “bad” in absolute terms, but are varying degrees of one or the other depending on your unique circumstances.

Define Financial Goals Independently of Fads or Trends

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Another way to partially insulate yourself from the effects of market bubbles is to define investment and financial goals with a sober mind. That is to say, you should deliberately set goals for things like net worth, debt-to-income ratio, the retirement lifestyle you hope to live and therefore how much you ought to save, your hoped-for investment return, etc. Furthermore, these goals should be decided solely by reference to fundamentally sound, time-tested principles and norms rather than the erratic market movements of the moment. Such a policy seldom lands you with all your money invested in one stock (a la Enron) or one category of stocks (like technology) or in a mortgage clearly unmatched to your financial resources (as in the recent housing bubble.) Instead, your knowledge of markets and your consciously chosen goals will help steer you away from such heedless risk taking and toward choices more likely to advance your purposes.

Do Not Instinctively Dismiss Skeptics

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Every bubble in U.S. history, from the Great Depression to Wall Street investing in the 80′s to technology in the 90′s and housing in the 2000′s, was predicted in advance. Unfortunately, the people who predicted them were so few in number that they were seldom taken seriously until their predictions had all too painfully come true. Despite what many believe, skepticism is not limited to Holocaust denial, UFO sightings or JFK conspiracies. There are factually sound reasons to be skeptical of all sorts of things, whether they are market trends, political movements or individual statements (such as Enron’s repeated assurances of higher and higher stock prices.) Therefore, it is a good idea when markets begin heating up to at least give passing consideration to what noteworthy skeptics have to say. Use your education in markets, business and psychology to assess whether any of their contentions make sense. Do your own research. And whatever you do, never take a questionable statement at face value simply because an authoritative-sounding person who “must” know better than you has said it.

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