FOOL ON THE HILL
An Investment Opinion

The Anatomy of a Bubble

By Bill Mann (TMF Otter)
December 15, 1999

During the last six weeks many sectors of the stock market have been on an absolute rampage -- the Nasdaq Composite Index has risen almost unabated from below 2800 to over 3600 before giving some of its gains back yesterday. This represents an increase of nearly 27%. This would be a pretty phenomenal annual rate of growth, but the fact that it has happened over the last 30 trading days is nothing less than staggering.

A review of the rates of growth of several issues over the same time period is even more stunning:

                                  11/1 Price  12/14   % Change

CMGI <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CMGI)") else Response.Write("(Nasdaq: CMGI)") end if %>                  $105      $205       95%
Internet Capital Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ICGE)") else Response.Write("(Nasdaq: ICGE)") end if %>  84       123       46%
Yahoo! <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: YHOO)") else Response.Write("(Nasdaq: YHOO)") end if %>                 183       333       82%
Digital Island  <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ISLD)") else Response.Write("(Nasdaq: ISLD)") end if %>         63       147      133%
Cisco <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %>                   73        98       34%

Even before the latest rise, many economists and pundits were working themselves into a lather about the growing bubble in American equity prices, particularly among the Internet and networking issues. The Economist, for example, had a feature article in its September 25 issue on the inflation in American share prices, pointing out some remarkable similarities between the current market and that of the 1920s. Among those similarities in a bubble economy are negative rate of household savings, soaring imports pushing American companies' current account deficits above 4%, soaring property prices in prime real estate areas, and excessive money supply.

But hell, why should we worry about a bubble? We're getting rich, right? Well, sort of. The Motley Fool does not advocate market timing, nor do we have any deeper insight as to whether we are in a bubble or not. But this does not mean that the Foolish investor should not remain vigilant, because if we are in a bubble, and if it does pop, there is going to be a great deal of harm done to the economy in general, far beyond the current prices of our stock portfolios.

The problem is, there is no such thing as a tool the government or the Fed can use to concentrate on leveling stock prices. Federal Monetary Policy works like Penicillin, it affects the entire economy, not just the issue causing the Fed concern. The reason is simple: Should American individuals and/or companies find themselves deep in debt at the time of the inevitable correction of the stock market, the fall in asset prices could feed upon itself as recessionary forces feed upon themselves. Could. What is more certain is that a drop in share prices similar to that of 1987, when the markets plunged 40% in the span of two days, is more likely to put America into recession, given that the number of individuals holding stocks has risen fivefold in the intervening decade.

So we may or may not be in a bubble. My own feeling (and this is as far as I will venture on the subject) is that we are, that there is a significant number of companies that are being valued more on the "Greater Fool" concept than anything fundamental. And just like every other bubble that has ever existed, the majority of us are wildly fond of the results thus far, and at times those preaching caution are just as wildly unpopular. Whether or not we are in a bubble, and if so, whether it pops instead of deflates now or in the future, is likely dependent upon the restraint of individuals and companies not to increase debt spending while the times are good.

History has given us many examples of bubbles. History being what it is, we can look at the causes, developments, triggers, and aftermath, and try to do so without casting aspersions on the current market. It's pretty simple to draw the parallels, it's also fairly easy to see the contrasts. But in the end, you are responsible only for your own interpretation of the overall economic situation and your reactions thereto. Each bubble that has existed has had a singular similarity: in the words of Burton Malkiel in A Random Walk Down Wall Street, "greed run amok."

One famous bubble took place in the early 1700s in England, starting with a company called the South Seas Company. This company was possessed with a poor sense of business but a fantastic sense of self-promotion. The company was set up to compete in the overseas merchant market, particularly in the transport of slaves in South America. Never mind that not one of the directors of the company had any experience in this market.

The company's directors offered to fund the entire British debt in exchange for monopoly status in commerce in the South Seas. Immediately, the share prices leapt threefold, though there was no underlying improvement in the company's business. The company began to raise the money it would need to fund the debt by issuing shares to those whose help was required to get the bill passed that would transfer the debt of the Crown to the South Seas Company. These shares were then "sold" back to the company at a profit.

The whiff of free money drove the English gentry into a frenzy. The belief that South Seas stock "had" to go up made it so. To meet demand, the company issued more and more shares at ever higher prices, rising to above �1000 per share, a nine-fold rise from the initial purchase price.

This fantastic rise in South Seas' price caused investors to search madly for "the next one." Poorly designed and unfeasible business prospectuses were rewarded with money from a public that was willing to buy nearly anything, just so it was speculative, and just so it promised magnificent return on investment. The promise of riches drove the price, nothing else.

The bubble was popped only when the directors of South Seas themselves sold their holdings in the summer of 1721, realizing that the price had no bearing on the reality of the business. This action caused a stampede of people to the exits, as there was a sudden moment of clarity amongst them that paper wealth does not have the same security as real wealth. This collapse was followed by a period of significant depression in England, and although there were a few winners (mostly the insiders), most everybody else felt the pain that the collapse in equity prices caused.

Will this happen again? Well, there are significant mechanisms in place that restrict the actions of insiders, and nothing like the Fed existed in 18th-century England. But there is not much that can fight against the mentality of a mob, and should the mob try to move to the exits really quickly, we may just find out if we were in a bubble or not.

Fool on, and watch that last step. It's a doozy. I mean, if it comes, of course.

TMF Seymor on the Market Bubble Jan 20, 1999

TMF Gump on the Market Bubble Jan 22, 1999