bubble – Andrew E. Scott

Thoughts on a Tech Bubble

I have been trying to get to grips with the meaning of investment “bubbles” for a couple of years now (for instance in this blog post about tulip mania). I first started to look into this during the local property boom when I was also studying finance. However, there’s increasing talk online of whether we are now in some sort of tech bubble, akin to what happened around the years 1999-2000 and resulted in the dot-com crash.

I wouldn’t say that I have a mature position yet on bubbles, but I think I know enough to say that we’re not in a tech bubble. At least, not yet.

One problem with a test for a bubble is that it is difficult to know for sure that you’re in one until after they’re over. For one sure sign of a bubble is that it ends in a crash – the bubble pops. At this point, prices of the investments in question drop quickly, and many people lose a fortune.

Other signs of a bubble, such as speculative investors (people investing because they expect prices to go up due to investor behavior not necessarily due to increase in underlying worth) or dodgy investments are present in most markets most of the time, and shouldn’t be a concern of themselves. You would hope that in a market there are a variety of positions being taken on investments for a variety of reasons, and that new investments can be introduced into a market if there is a demand for them.

Also, many markets are naturally cyclical, with regular booms following busts over time. Just because a market is hot doesn’t mean it’s in a bubble, although it probably means prices are higher than otherwise warranted, in which case you’re unlikely to pick up a bargain. But people investing for the long-term with diversification across different markets can typically ride-out a cyclical decline.

That said, the first reason I don’t believe we are in a tech bubble is that currently a decline in the value of tech start-ups wouldn’t result in the average punter losing a fortune, because the average punter is not able to invest in tech start-ups. We’re not in a situation, like back in 2000, where an ordinary investor can invest in the latest crazy tech stock on the NASDAQ. It is really VCs and Angels who are taking the risks right now. So, we can’t yet experience the sort of widespread disaster that characterizes a crash.

The other reason I don’t think even the keen anticipation for the Facebook IPO could make this a bubble is that a bubble is a description of a market and not a single investment. You can’t really talk of a 13 Pearl St Essendon bubble or an Enron bubble (even while their stock did crash and wipe many people out). We would need to see average people investing in a variety of new tech companies for there to be a bubble in the tech market.

But there may be signs that this could yet occur. Services like Kickstarter and IndieGoGo have sprung up that allow everyday people to pledge or commit money to a cause, which might be to bring a product or service to market. If causes start to take on more investment characteristics, this begins to look like a means for early stage investment in tech companies.

If I start to hear about people extending the mortgages on their homes to put funds into Kickstarter projects, I will be worried that we’re in a bubble, but I’m not worried yet.

Perhaps there was no Tulip bubble

I’ve been trying to understand what a financial bubble really means, and in the course of this, came across some interesting information: apparently the great Dutch Tulip bubble of the 1630s wasn’t a bubble after all. Although I am wary to merely summarise stuff that is written better elsewhere, I thought this was a good one to share.

Background

Tulips came to the Netherlands from Turkey in the 1500s, and became a popular status symbol. Multicoloured varieties were produced due to the effects of a plant-specific virus, and as a result (skipping the details), it would take at least seven years after planting the bulb of a spectacular tulip to produce new tulips from it. Understandably, possessing a spectacular tulip bulb gave you an advantage for quite a period of time before others could gain a similar bulb.

Due to rising prices, speculators entered the tulip market in 1634, and a more formal futures market in bulbs arose in 1636. By some accounts, offers for single bulbs reached insane levels, e.g. 49,000 m^2 of land for a bulb. In February 1637, the price of tulips crashed. For the next few centuries, “tulip mania” is used as a textbook example of crazy market behaviour with a boom and bust.

Why not a bubble?

If a bubble is where markets are caught up in “irrational exuberance”, then it appears that this market continued to be rational. And if a bubble is where a market eventually “pops” and the resulting crash causes widespread losses, then it appears that losses were not significant. Of course, it is hard to know for sure, since all of this happened almost four centuries ago, but there is apparently some evidence that:

In February 1637, the futures contracts all became options contracts, i.e. the purchaser of a contract to buy bulbs no longer had the obligation to purchase or take delivery of the bulbs if it looked like they would make a loss.
This change was known to be coming from several months beforehand, encouraging purchasers of contracts to agree to high bulb prices with minimal risk. Taking this perspective, the contracts were rationally priced.
Actual tulip prices (as opposed to the price of these futures contracts) remained at ordinary levels.
The Dutch authorities halted the trade in the contracts, and later decreed them unenforceable gambling debts. So, given that no tulips changed hands that winter (as the tulips would’ve all been in the ground) and the contracts were unenforceable, it’s not clear that there were any significant losses made.
Most of the support for claims of a tulip bubble come from some anti-speculation propaganda published soon afterwards.

Perhaps, then, there was no Tulip bubble. I guess all those textbooks need updating.

Housing Boom or Blame Boom?

There’s talk again of the house price boom (or even bubble). I know people who are looking to buy at the moment, and I feel so lucky that I’m not having to find a first home in the current market.

However, stories I read in the media suggest to me that we’re also in the midst of a blame game, where various bogeymen are out there pushing up prices to the detriment of everyone else. If you believe everything you read, we can blame:

First-home buyers – whose free cash from the government in the form of the FHOG (First Home Owners Grant) is making it hard for others to compete.
Overseas investors – who are apparently making the most of relaxed rules from the FIRB (Foreign Investment Review Board) to invest in Australia when other international markets are looking shaky and depressed.
Local investors (in particular Baby Boomers and Gen X) – whose access to the tax deduction of negative gearing enables them to sustain larger holding costs of property than non-investors.
Developers – who have been slowly releasing lots from their land banks rather than supplying enough to the market to meet the demand
Immigrants – who have been coming here in increasing numbers because it has a promising way of life but are now competing with the locals for somewhere to stay.
Governments – for allowing all of the above to occur.

Is there anyone left?

What is good in this debate is the recognition that it is supply and demand that is driving the prices in the market. However, the purpose of this finger-pointing seems to be to blame everybody else for the problem. I’m not convinced that any of the above factors are at the heart of the matter:

First-home buyers – the demand from these guys doesn’t explain why an unrenovated house in Richmond sells for more than $2m (as I read in yesterday’s paper). The whole market is booming, not just the cheaper end.
Overseas investors – although they are active, they are still a minority. I don’t think they could underpin the entire boom.
Local investors – negative gearing also results in lower rents than would otherwise occur, which should in turn reduce the demand for home ownership.
Developers – their land is generally at the fringe, and there is heavy demand in the centre.
Immigrants – these are a net benefit to a society, since they generate taxes and jobs, but have always been an easy target.
Governments – there is some truth to the saying that in a democracy, we get the government that we deserve. If governments continue to follow policies that we don’t agree with, we can only blame ourselves for voting them in.

On the other hand, a factor that I don’t think has gotten enough attention is our culture. In particular, the “Australia dream” of owning a house on a block of land.

I worry that it is the pursuit of this goal, more than any single segment of society, that is driving the demand for houses in the suburbs of our capital cities. We need to give up on this dream if we are to achieve sufficient densities in the inner ring of suburbs where most people wish to live.

Rather than blaming other people, I can fess-up to being as guilty as everybody else on this one. A couple of years back, Kate and I bought a house together that would’ve housed a family of five when it was designed and built around 1900 in Kensington. This is a typical, gentrified, ex-working-class neighborhood of Melbourne that probably has lower densities now than when it was new. We moved out after we had our first child, because it was too small for us (!).

In the same way that governments around the world have influenced the cultural desires for a certain family size, it ought to be possible to embark on a campaign to change our cultural expectations and change this demand factor. Make living in high-density accommodation the trendy option. Guilt people out of their large houses with empty rooms and private back yards. (Other countries have a higher density of living than us, hence why many immigrants are willing to live in apartment blocks that locals would avoid; another reason why immigrants aren’t contributing as much to the problem.)

At the same time, there needs to be more direct incentive to motivate people to embark on such a change. Make subdivision easier. Make building apartments on new land easier. Ensure that apartment blocks are built well (good climate control and sound/smell proofing) and there is provision for common outdoor areas.

I’ve spent most of my years since I left home living in higher density accommodation such as apartments and townhouses. Although I’m currently living in a house, I think I’d be willing to share walls again.