Tuesday, January 27, 2009

Boomer’s Wake Rule #5 – Understand That We Are Addicted to Bubbles!

Boomer’s Wake Rule #5 – Understand That We Are Addicted to Bubbles!

Find me some good old fashioned supply and demand combined with a little hype and mass potential for easy wealth and I will show you the makings of economic bubble.  Without rewriting the terrific examples of the classic and historical bubbles such as Tulip Mania, (See Wikipedia http://en.wikipedia.org/wiki/Tulip_bubble), I will summarize what is generally present in economic bubbles so we can start to learn how to spot them, and more importantly, learn to profit on the way up or even profit on the way down.

Bubbles generally occur when accelerating mass awareness and demand for a particular investment or asset is combined with an individual’s ability to enter and exit the transaction relatively quickly, amassing quick wealth in the process. 

The potential for unskilled and uneducated investors to make easy money without obtaining the proper level of training or experience combined with the lack of complex barriers to entry help turn a simple investment trend into a bubble.

And bubbles continue to grow until the top, when the most inexperienced and undisciplined investors are just getting in and the most sophisticated and early investors are getting out.  These tops tend to be well timed with excessive supply or new alternatives being added to the market well in excess of the natural demand.    

Bubbles are very easy to spot AFTER they crash.  Here are a few charts showing the some famous bubbles, before and after:


South Sea Company:

1929 Stock Market Crash:

Dot Com Bubble:

Housing Bubble:

Do you see any patterns ?  Of course!  The most interesting, an painful thing to most investors, is that in almost all bubbles, the crash seems to go even lower than where the accelerated gains started picking up steam.  Bubbles end up taking everything back, and more!

So, how can this make us money? 

First, let’s come to agreement that we are addicted to bubbles.  Money seems to be moving from one bubble to the next.  From tech in the '90s to Real Estate in the 2000s to China in 2004/5 to Energy in 2006/7 and now to US Treasuries and other “safe” investments today.  It is pretty likely that eventually, money will move out of treasuries and pour into the next bubble.  So we better figure out how to spot the trend early enough to make some money!

If we learn to understand the psychology of bubbles, we can learn to spot them easily and quickly.  The following chart is a great example of the full cycle and various stages of a bubble/bust and what the general mood is at each stage:

So, at which state should we to to get involved? 

There is obviously nice growth from the Stealth Phase to the Awareness.  Everyone wants to be in the next Apple at the startup.  But that generally requires some inside knowledge, industry expertise, luck and timing.  If you were interested in getting into dot com in 1992, would you pick the right company? Or would you end up investing in Wang Labs and Lotus Notes instead of Dell and Microsoft, missing out on the entire trend?

I think a more realistic approach is to keep an eye out for when the media attention phase kicks in and accelerates the investments toward the mania phase.  If we set our goal to capture the middle 1/3 to 1/2 of the move, we will do just fine, not be too early and not overstay our welcome either.  As you can see from the charts, the bubble bursts quickly and painfully and if we are left to our own emotion, we could hold on with undue optimism as we fall into the “Bull Trap” and end up losing everything we invested, and more.  

And on the way down?   If we are sharp enough to determine when a bubble is about to pop, we can look for signs of denial by investors still going long.  We can short the worst companies in the sector in the first bull trap on the way down.  If we are good and a little lucky, we can make a killing... Twice!

So how do you know when you are in the delusion stage and headed to the first stages of denial?  I like to use recent history as our guide.  Think back to a few of the past bubbles and try to remember the media climate and general buzz in the air.  Here are some examples of the many observations we made at the tops of the past bubbles and can make at the tops of the next ones:

  1. It becomes front page of every magazine and newspaper.
  2. Your uncle, hair dresser, neighbor and local bartender are all getting involved.
  3. Average people are making a killing investing in an area that just seems too good to be true.  They are even considering changing their careers to do this full time because it is so easy.
  4. You are wondering why everyone else is smarter than you and making all that money while you know something is wrong.
  5. You hear terms like “Different this time”, “New Paradigm”, “Throwing out the old rules”, etc…
  6. The professionals stop using “old” metrics like profit, positive cash-flow, etc...
  7. The worst companies in the sector go up with the entire group, reaching illogical levels.
  8. Lots of new supply becomes available while true demand becomes flat or even starts to decline.  We simply run out of new buyers.

You get the point!  If we live in a new reality of bubbles, we need to practice spotting them.  In future Boomer’s Wake articles, we will refer to various stages of bubbles as we seek out investment opportunities.  You will want to get to know these phases by thinking back to the last 3 or 4 bubbles and noticing things that could have been easily detected with just a little clarity and focus.  Start looking through the eyes of a Boomer’s Wake Bubble Watcher.

So, what bubbles could be next? 

Some say Treasuries/flight to safty is already in a bubble.  With sub 1% interest rates, there isn’t much room for them to go from here.

Hard assets like gold could be next as we flood the world with currencies to fight the recession/depression

Alternative energy could become in bubble vogue now that it is a national priority

So the bottom line is this.  Keep your eyes open and expect the next bubble!  It could make you rich!