How to avoid participating in bubbles

I'm just an average Joe, though averse to plumbing. But I've known that it would all blow up the moment I saw people taking ARMs while the interests rates were the lowest in history and even interest-only mortgages. I knew it would blow up in their faces when their ARMs would expire the "grace-period" or when they would have to start paying the principal. I just had no idea that it would blow up in my face too (that comes from being a Joe), though my mortgage payment is currently less than what rent would cost.

If I can learn anything from this housing bubble and from the .com bubble, I think is that when people are confident that prices or value can only go in one direction, people stop assessing goods realistically. Rather, wishful thinking about value is the norm. It seems that bubbles have been like this since the tulip frenzy in the

1600s.

It also seems to be the case that bubbles take place with non- productive goods, be them tulips, a piece of software that everyone will want one day, or a house larger than one needs. It's true that economic value is something subjective, but the necessities of life usually trump what is merely to caress one's ego. In other words, goods which can be used to contribute to the economic output are the ones that we will value at the end of the day, ignoring the colors of tulips, the bells and whistles from a computer or the empty spaces of a large cardboard house.

Reality has this thing about kicking in sooner or later, when everyone realizes that the king has no clothes, only to realize that their own clothes are perhaps all they have.

HTH

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snip for brevity

I think the above in particular is a good warning sign. It brought to mind very precisely the commentary by Jason Zweig, in the latest edition of Ben Graham's _Intelligent Investor_, after Chapter 1, concerning speculators. Zweig comments on the late 90s bubble and how trading by specific people with little sophistication in stocks was a sign that the masses were speculating, not investing.

For the interested reader, a link to Graham's Chapter 1 and Zweig's comments:

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The classic book on bubbles is Extraordinary Popular Delusions and the Madness of Crowds by Charles MacKay. It discusses bubbles all the way back to the tulip craze. Read it and bubbles become real easy to recognize.

-- Doug

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We are coming off an oil bubble, so it doesn't just apply to non-productive goods. -- Doug

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This is a must read book for any investor. If I remember right, I read it 1996.

Augustine, I snipped the rest of your post for brevity, but I want to say that it was a great post, as far as I am concerned. I think that besides recognizing a bubble in progress, which you described, one also need some degree of strength to stay away from bubbles and not get suckered into the "I will get out early" mentality.

i

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That's true. But I wonder about the scope of oil speculation. It surely affects everyone, but only on the way up, not on the way down. In other words, it seldom went up catastrophically and it never came down like that, at least for those who use it, not sell it.

Could this pattern be applied to all productive goods?

Then again, as the OP said, the bubbles were particularly characterized by credit beyond one's means and disposable assets. Is this always true?

TIA

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Learn to love bubbles, at least the more limited ones without collateral damage! Like the China one... very easy to recognize joining for some upside and not that hard to tell when to get off before getting all gains zeroed out

It's just hard to resist rejoining such things during the bear rallies. You only need a little luck in not joining too late, and discipline in getting out (trailing loss sell order, and then off to money market or an alternative bubble)

Well, that's a bit extreme just to make a point, and most bubbles should probably be treated as toxic. But where would most of us be if not for some of the more mellow bubbles? If I had depended on SP500 indexing I would be not only poorer but would have mentally numbed my interest in finance.

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I beg to differ. It's difficult to recognize bubbles in progress. For example, many of us saw there was a real estate bubble (if you lived on either coast, this was clear) but how many saw that this bubble would pop and implode fixed-income investments? Very very few. Almost nobody I would argue, except a few Wall Street bond analysts talking to their fellow analysts in private, and even then just speculating.

As for MacKay's book, it's been debunked (I think Kindelberger has written on this) by a late 1980s revisionist author who points out that certain tulips were indeed very rare and worth what people were paying for them--precisely the same way as a rare gem is worth a lot of money. Also, the prices were not as extreme as people suggest, further, certain stories are apocryphal (like the starving drunk sailor who ate a rare tulip for lunch), and finally, there were two different tulip markets: one where you had to put down a real down payment for an actual tulip, a kind of futures market, and another, akin to today's derivatives, which was not based on any physical underlying tulip, but a gamble on which way prices would move. Poor people speculated, with no down payment (sound familiar? like our Alt- A "NINJA" mortgage loans), on the latter market, which had no basis in reality and quickly became overinflated. It is this market that people call the tulip market, but, as the revisionist pointed out, it was by far the less important market commercially. The rich and real merchants only invested in the first market.

RL

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And some of us are quite happily retired for having done so in large part.

Elizabeth Richardson

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Let's not mix up recognizing the bubble and predicting the consequences.

Around here, we talked about the housing "bubble in progress" as early as 2005. The earliest (that I can find) we talked about fixed-income investments cratering was June of 2007.

I say again. Bubbles are easy to recognize. I'll agree with you that the fall out is difficult to predict.

-- Doug

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A more modern, and more financially-oriented book is _Devil Take the Hindmost_ by Edward Chancellor. A great read and it really shows that nothing ever changes.

-- Rich Carreiro snipped-for-privacy@rlcarr.com

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Another revisionist account of the "Great South Seas" bubble

as well as thecoincident scheme by John Lay is that essentially this was an early attempt atmodern deficit spending. The theory being: issuing worthless shares for money was a first attempt to do what modern governments do everytime they sell government bonds--monitizing the debt.

Trouble is, the South Seas promoters and John Lay in the Miss. scheme overestimated demand. But for that mistake, it would have been a great success.

This according to a revisionist historian (somewhat tongue in cheek, as a criticism of modern government deficit spending, but his point is well taken to a degree).

RL

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