1. The dot.com bubble
Bubbles in context
Martin Upton
Hello. I'm Martin Upton from the Open University. I'm here with my colleagues Jonquil Lowe
and Alan Shipman and today we are talking about investment bubbles.
First of all Alan, can you define for me what a bubble is?
Alan
It isn't 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 equity
market, rise substantially above the level that one could ascribe to their fundamental or
intrinsic valuation. Knowing what the intrinsic value is is always difficult. One can rationalise
that the price of a share should be the present discounted value of the future profit that it's
going to generate for shareholders. But knowing what that is is always speculative and there
can be reasons why sometimes the share price gets revised upwards quite substantially on
the basis of new information. People would tend to say a bubble is occurring when valuation
is getting very high across the board and investors seem to be piling into a market largely
because other investors have already done so especially if those investors are borrowing
heavily to increase the amount of their investment. And the fear is that prices will go too high.
Once they're detached from fundamentals people actually start trading on the upward
momentum 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 and
haven't got out in time.
Martin
I find it very hard to distinguish between a bubble and a sharp price movement in an asset of
whatever type for good fundamental reasons. I'm looking at today’s FT and I'm seeing that in
the last year iron ore has gone up in price by a hundred and seventy per cent; nickel by a
hundred and thirty seven per cent; copper by ninety per cent and aluminium by a meagre
sixty per cent. So for all those four commodities are those four commodity bubbles?
Alan
Some people would argue that because they would say well the price of those commodities
should be determined by global supply and demand. And in fact some of the producers of
those commodities try to use rising and falling stocks to regulate the price and to stop it rising
or falling very rapidly. So if it is being chased upwards suddenly that could be because some
people are speculating in it, building up stocks in it, following the price up and actually

2. 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 very
rapidly and there is a real growth in demand and that’s the reason for the price increase. This
is what makes it so difficult to determine whether rapidly rising asset prices are a bubble
phenomenon or a real phenomenon. And with commodities it's particularly difficult because
the stocks are not visible and people don’t know whether it's the holding certain supplies off
the market that is causing the price increase or whether they are genuinely passing through
the market and being bought and used up in production.
Martin
We've talked about bubbles in the context of the stock market and the context of commodities
but there's 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 came
to a bit of a sort of sudden end in 2007 although actually in the last year house prices have
recovered again.
So Jonquil, do you think that housing in the UK – that’s another bubble?
Jonquil
It's very hard to say. This comes back very much to what Alan was saying about the
fundamental value of an asset and the difficulty in determining what that is. For many years
with house prices rising there's been an argument that well in the UK land is scarce. We are
seeing more households because more people are choosing to live alone. Families are
divorcing and so there is excess demand for housing. And that seemed to be a rational
reason for house prices to rise. But equally you can say, well the rise has been very rapid. If
you plot it on the charts you know there's been a very steep rise in the last few years and of
course we have seen a fall back. And if you look at the affordability of housing, especially for
first time buyers, the multiple of earnings now is around four and a half times earnings to buy
a first property whereas the long term trend has been about two and a half. So on that basis
you could say, yes well housing still looks very over priced and maybe this is a bubble but it
really does show the great difficulty in recognising the bubble.
Alan
Housing is especially sensitive in economies like Britain with a very high proportion of home
ownership. We've seen the government desperate to stop house prices falling especially
when people have been borrowing on mortgages with a high loan to value ratio because the
price fall can push households into negative equity and actually give serious financial
difficulties to them if they have to sell the property at that point. So I think we've seen
government policy adjusted in the form of the very low interest rate to rescue the housing
market before it can decline significantly. And that raises a question which I think a lot of the

3. people arguing for the continuation of bubbles would point to which is when the government
holds interest rates down for a long time or when an independent central bank like the Bank
of England holds interest rates near to zero for a long time that does put a lot of credit growth
into the system and that credit is going to generate spending on some commodity somewhere
so something will bubble up in those conditions. If it's not housing next it might be emerging
markets. It might be green technology. Something else quite possibly will be going through a
bubble now because of the supply of cheap credit.
Martin
Okay. You can apply the term bubble then to various asset classes and to various different
markets. But to my mind a pure bubble really relates to something which is new: a new asset,
a new device, a new market where there's no track history of financial performance so
investors and other participants don’t know how to value the companies engaged in the
production of the new thing. Do you think that’s fair?
Jonquil
Yes I think there is something in that. We’ve seen it with the dot com bubble. You see it with
biotech companies say. There's a lot of excitement about what these companies might
produce in the future, what profits they might produce for investors. But because there is no
track record and because the are in a development phase the future earnings are projected
forecast – guessed if you like -
Alan
Made up –
Jonquil
Absolutely. And so you know what is the value of this company that’s got great future
prospects but isn't actually producing today. And interestingly sometimes the market can be
right about the innovation but not necessarily right about the companies so an example was
the railway mania in the 1840’s when it was correctly identified that railways would
revolutionise the economy but in fact it wasn’t really the shareholders of railway companies
who saw that return.
Alan
When it comes to bubbles we tend to focus on the losers, the people who invest in companies
and end up with pennies if they’re lucky. But there is the other side to the notion of a bubble
and these bubbles are often very useful aren't they?
Yes - governments do worry a lot and ordinary citizens worry a lot but we might actually not
invest enough and not grow the economy fast enough because of that low rate of investment.

4. Bubbles, because they make financial capital available cheaply they reduce companies costs
for capital can actually boost company investment in a way which is publicly beneficial even if
it's not privately beneficial to the shareholders and creditors. We certainly saw that with the
railway boom in the 1840’s. Most of Britain’s railways were built at that time. Very few have
been built since. So we today should be enormously grateful for those who mismanaged their
fortune by investing in that 1840’s railway bubble. We are still getting the public benefits from
it. The same could well be happening today with green technology which ahs been absorbing
a very large amount of venture capital and has been tipped by some to be the next bubble. It
could well be that a lot of private investors in green technology will not get benefits but the
more solar cells we install, the more wind farms are set up the better that’s going t be for the
public in general and the economy in general. So to a certain extent tricking investors
through a bubble can have good lasting benefits for the community.
Martin
I just wonder if bubbles also exemplify the issues to do with the different degree to which
people hold information about investments. We talk about the markets being efficient and you
can't buck the markets. But when it comes to understanding how a stock or an asset or a
commodity might move in price well some people on the inside they know and have a pretty
good idea about the valuation on a particular asset and some are hovering on the outside and
they're more vulnerable.
Jonquil
Yes though acting rationally as an investor isn't just about getting that intrinsic value right. It's
also about guessing what other investors are doing about how other investors are valuing the
company so you can have what you could call a rational bubble where you know something is
overpriced but because you think that other investors will carry on investing the prices will still
go up and so it's still rational for you to invest now as long as you pull out in time. So it's not
necessarily an indication of irrational behaviour or necessarily an inefficient market.
Alan
But what we've often seen is the professional investors in the end doing better than the small
private investors. They are the ones who manage to stay in until very late but still get out in
time and it's the more ordinary people in the street who have gone into the market when it's
already a long way up and who have stayed in it too long who tend to suffer the sudden loss
of capital when the bubble bursts.
Martin
So the same old story basically. The people on the inside in the know will tend to get out in
time and the poor hapless individual investor is going to be the one that’s going to end up
making losses.

5. Alan
Quite possibly and it is because the professionals have the information and have the ear to
the market much more than the ordinary investor in their front room is likely to do.
Martin
Well life would be less exciting without bubbles and we have seen that they do have desirable
consequences -------