Financial bubbles occur when enough people start irrationally paying over inflated prices for stocks, collectibles, wine, cars, real estate, commodities – even tulips! The greater fool theory drives many price bubbles - while it is foolish for me to pay the current inflated price, there is a good chance that someone even more foolish is willing to pay even a greater price in the future!
The first famous financial bubble was the Tulip Bubble back in 1637. A single tulip bulb was bought for as much as 2,500 Florins ($1,250 in current US Dollars). Tulip bulbs became so valuable they were used as a medium of exchange. In 1637 Holland you could purchase most anything with a tulip bulb. A good tulip trader back then could make the equivalent of $60,000 per month, with that kind of profits the local government could do nothing to impede the trading activity. One day a buyer failed to show up and pay for his tulip bulb purchase. That ignited a panic, and within days tulip bulbs were only worth a tiny fraction of their former prices. Fortunes lost!
Looking back to the Tulip bubble it is easy to see how foolish the Dutch market participants behaved. Unfortunately, humans are prone to be attracted to things that look appealing, especially when a lot of other people are talking about it and the press is also doing their part building the hysteria. Irrational behavior becomes acceptable when it appears that enough people are following along. It is only after the return to normal that we look back, shake our heads and wonder what had come over us!
Right now could we be watching two notable bubbles? The stock of Amazon and the price of a Bitcoin.
Amazon (AMZN), the global on-line retailer, is trading at 197x its earnings per share of $5.31 at $1,051. A price increase of over 400% the past five years. Comparatively, Apple Computer is trading at 18x earning the Standard & Poors 500 on average is trading at 24x earnings. So right now the market is telling us that Amazon is worth 8x as much as the average stock in the S&P. This is great news if you own Amazon stock. Could it go higher? Of course! However, the rational move would be to sell or at least pare down your holdings and sell at the inflated price. Even Jeff Bezos is systematically selling his shares to diversify into other ventures, this year he sold over 1 million shares leaving him with only 79 million or so. It just does not make sense for him not to diversify. Over the years I have seen several stocks that could nothing but goes up until they didn’t. Merck Drug, FNMA, Coca Cola all have seen remarkable periods of returns until the capital flows stopped. Merck (MRK) for example was trading around $100 per share in October of 2000 a remarkable six year run from $14 in 1994. It had everything going for it, technology, capital, new products, expanding market, great management, etc. If you had a portfolio, you had to have MRK! Five years later in 2005 Merck had dropped to $27 – down 70%. No idea what Amazon will do in the future, but there is no way that it can maintain these returns, at some point, there are no more fools – don’t be the last one in!
Bitcoin is different from a stock and is more like a digital nugget of gold, existing only in a cryptic electronic world. Bitcoin was designed to be a non-traceable digital currency. Of course, it has all of the characteristics that central banks and big government despise. Seven years ago one Bitcoin was worth $0.08 today the same Bitcoin is worth $2,433. A $1,000 investment in Bitcoin in 2010 is now worth around $28 million. Is Bitcoin the ultimate example of a bubble? It would have certainly been difficult to hold on this long without selling.
Any price run or bubble has one thing in common for most of us. Had I only known I would have bought some and held on! But that is always after the run-up. The greater fools will always be the last ones to buy. Can you be a wizard though and buy enough of an abstract or out of favor security to make a difference and hold on waiting for the rest of the market to start piling in?
Here is long term look at Amazon, Merck and Bitcoin. See any similarities? Of course, no way to predict what is going to happen. But one thing for sure. no holdings can perpetually run up. The fall can be painful for the “fools” who got in late.
Stay diversified and do not get sucked into these bubbles after they have already inflated. Who knows, something you have been patiently sitting on for years could be the next bubble – if that happens, of course, you would be the seller, cashing in after the run-up.