The dot.com bubbleBubbles in contextMartin UptonHello. Im Martin Upton from the Open University. Im here with my colleagues Jonquil Loweand Alan Shipman and today we are talking about investment bubbles.First of all Alan, can you define for me what a bubble is?AlanIt isnt easy. We normally know them after they’ve occurred, risen and burst but not before.Essentially a bubble occurs when the price of an asset, very often prices on the equitymarket, rise substantially above the level that one could ascribe to their fundamental orintrinsic valuation. Knowing what the intrinsic value is is always difficult. One can rationalisethat the price of a share should be the present discounted value of the future profit that itsgoing to generate for shareholders. But knowing what that is is always speculative and therecan be reasons why sometimes the share price gets revised upwards quite substantially onthe basis of new information. People would tend to say a bubble is occurring when valuationis getting very high across the board and investors seem to be piling into a market largelybecause other investors have already done so especially if those investors are borrowingheavily to increase the amount of their investment. And the fear is that prices will go too high.Once theyre detached from fundamentals people actually start trading on the upwardmomentum and reinforce that momentum and having gone too high they come down very,very steeply and wipe out those who have borrowed in order to get into the market andhavent got out in time.MartinI find it very hard to distinguish between a bubble and a sharp price movement in an asset ofwhatever type for good fundamental reasons. Im looking at today’s FT and Im seeing that inthe last year iron ore has gone up in price by a hundred and seventy per cent; nickel by ahundred and thirty seven per cent; copper by ninety per cent and aluminium by a meagresixty per cent. So for all those four commodities are those four commodity bubbles?AlanSome people would argue that because they would say well the price of those commoditiesshould be determined by global supply and demand. And in fact some of the producers ofthose commodities try to use rising and falling stocks to regulate the price and to stop it risingor falling very rapidly. So if it is being chased upwards suddenly that could be because somepeople are speculating in it, building up stocks in it, following the price up and actually
creating more upward momentum for the price. And it is detached from the fundamentals.Some would argue that and others would say in fact the world economy is recovering veryrapidly and there is a real growth in demand and that’s the reason for the price increase. Thisis what makes it so difficult to determine whether rapidly rising asset prices are a bubblephenomenon or a real phenomenon. And with commodities its particularly difficult becausethe stocks are not visible and people don’t know whether its the holding certain supplies offthe market that is causing the price increase or whether they are genuinely passing throughthe market and being bought and used up in production.MartinWeve talked about bubbles in the context of the stock market and the context of commoditiesbut theres one potentially other bubble, which is closer to home – the UK housing market.Now we saw prices in the housing market in the UK rocket between 1995 and then it all cameto a bit of a sort of sudden end in 2007 although actually in the last year house prices haverecovered again.So Jonquil, do you think that housing in the UK – that’s another bubble?JonquilIts very hard to say. This comes back very much to what Alan was saying about thefundamental value of an asset and the difficulty in determining what that is. For many yearswith house prices rising theres been an argument that well in the UK land is scarce. We areseeing more households because more people are choosing to live alone. Families aredivorcing and so there is excess demand for housing. And that seemed to be a rationalreason for house prices to rise. But equally you can say, well the rise has been very rapid. Ifyou plot it on the charts you know theres been a very steep rise in the last few years and ofcourse we have seen a fall back. And if you look at the affordability of housing, especially forfirst time buyers, the multiple of earnings now is around four and a half times earnings to buya first property whereas the long term trend has been about two and a half. So on that basisyou could say, yes well housing still looks very over priced and maybe this is a bubble but itreally does show the great difficulty in recognising the bubble.AlanHousing is especially sensitive in economies like Britain with a very high proportion of homeownership. Weve seen the government desperate to stop house prices falling especiallywhen people have been borrowing on mortgages with a high loan to value ratio because theprice fall can push households into negative equity and actually give serious financialdifficulties to them if they have to sell the property at that point. So I think weve seengovernment policy adjusted in the form of the very low interest rate to rescue the housingmarket before it can decline significantly. And that raises a question which I think a lot of the
people arguing for the continuation of bubbles would point to which is when the governmentholds interest rates down for a long time or when an independent central bank like the Bankof England holds interest rates near to zero for a long time that does put a lot of credit growthinto the system and that credit is going to generate spending on some commodity somewhereso something will bubble up in those conditions. If its not housing next it might be emergingmarkets. It might be green technology. Something else quite possibly will be going through abubble now because of the supply of cheap credit.MartinOkay. You can apply the term bubble then to various asset classes and to various differentmarkets. But to my mind a pure bubble really relates to something which is new: a new asset,a new device, a new market where theres no track history of financial performance soinvestors and other participants don’t know how to value the companies engaged in theproduction of the new thing. Do you think that’s fair?JonquilYes I think there is something in that. We’ve seen it with the dot com bubble. You see it withbiotech companies say. Theres a lot of excitement about what these companies mightproduce in the future, what profits they might produce for investors. But because there is notrack record and because the are in a development phase the future earnings are projectedforecast – guessed if you like -AlanMade up –JonquilAbsolutely. And so you know what is the value of this company that’s got great futureprospects but isnt actually producing today. And interestingly sometimes the market can beright about the innovation but not necessarily right about the companies so an example wasthe railway mania in the 1840’s when it was correctly identified that railways wouldrevolutionise the economy but in fact it wasn’t really the shareholders of railway companieswho saw that return.AlanWhen it comes to bubbles we tend to focus on the losers, the people who invest in companiesand end up with pennies if they’re lucky. But there is the other side to the notion of a bubbleand these bubbles are often very useful arent they?Yes - governments do worry a lot and ordinary citizens worry a lot but we might actually notinvest enough and not grow the economy fast enough because of that low rate of investment.
Bubbles, because they make financial capital available cheaply they reduce companies costsfor capital can actually boost company investment in a way which is publicly beneficial even ifits not privately beneficial to the shareholders and creditors. We certainly saw that with therailway boom in the 1840’s. Most of Britain’s railways were built at that time. Very few havebeen built since. So we today should be enormously grateful for those who mismanaged theirfortune by investing in that 1840’s railway bubble. We are still getting the public benefits fromit. The same could well be happening today with green technology which ahs been absorbinga very large amount of venture capital and has been tipped by some to be the next bubble. Itcould well be that a lot of private investors in green technology will not get benefits but themore solar cells we install, the more wind farms are set up the better that’s going t be for thepublic in general and the economy in general. So to a certain extent tricking investorsthrough a bubble can have good lasting benefits for the community.MartinI just wonder if bubbles also exemplify the issues to do with the different degree to whichpeople hold information about investments. We talk about the markets being efficient and youcant buck the markets. But when it comes to understanding how a stock or an asset or acommodity might move in price well some people on the inside they know and have a prettygood idea about the valuation on a particular asset and some are hovering on the outside andtheyre more vulnerable.JonquilYes though acting rationally as an investor isnt just about getting that intrinsic value right. Itsalso about guessing what other investors are doing about how other investors are valuing thecompany so you can have what you could call a rational bubble where you know something isoverpriced but because you think that other investors will carry on investing the prices will stillgo up and so its still rational for you to invest now as long as you pull out in time. So its notnecessarily an indication of irrational behaviour or necessarily an inefficient market.AlanBut what weve often seen is the professional investors in the end doing better than the smallprivate investors. They are the ones who manage to stay in until very late but still get out intime and its the more ordinary people in the street who have gone into the market when itsalready a long way up and who have stayed in it too long who tend to suffer the sudden lossof capital when the bubble bursts.MartinSo the same old story basically. The people on the inside in the know will tend to get out intime and the poor hapless individual investor is going to be the one that’s going to end upmaking losses.
AlanQuite possibly and it is because the professionals have the information and have the ear tothe market much more than the ordinary investor in their front room is likely to do.MartinWell life would be less exciting without bubbles and we have seen that they do have desirableconsequences -------