The brave new world of finance-6: Greed and bubbles »« Everybody should be converting

The brave new world of finance-5: Crystal ball economics and the rise of bubbles

(For previous posts in this series, see here.)

My first real awareness that my understanding of what constituted sound economics and business practices was orthogonal to how Wall Street viewed it came in the 1990s when company after company sought to increase its stock price by slashing its work force, thus increasing its profits (at least in the short term). I recall that the head of Eastman Kodak at that time fought this expectation that he too follow suit. His argument was simple: His company made products that were in demand, was price competitive, and was making good profits. Why should he get rid of good, loyal, experienced workers, the very people who had made the company successful, for no good business reason but merely to drive up the stock price? I thought he made complete sense, which just shows how much I knew. Outraged stockholders quickly organized his ouster and replaced him with a new CEO who did what they wanted, which was to ruthlessly reduce the payroll, in the process throwing tens of thousands of people out of work. But those actions did drive up profits in the short term, and the stock price rose, which is all that Wall Street cares about. The fate of the Kodak CEO was a warning to other CEOs that they had better not even think about putting the long-term health of the company or its employees above the short-term profit needs of the stockholders.

What seems to have happened that is driving this trend is that the line between appearance and reality in the financial sector has become increasingly blurred. For example, it seems to me that a company’s stock price should reflect its actual performance. So when it releases its annual report that says how well it did the previous year, its stock should rise if the report is good and fall if the report is bad. But that is not the way it works anymore. We are told sagely by analysts that what Wall Street cares about is not the data-based present (what some of us like to call ‘reality’) but expectations for the future. The measure that is used to determine stock price is how the report compares with what ‘experts’ and ‘analysts’ predicted it would say. What determines a stock price now is what analysts expect will be its profits in the future. We have moved from reality-based economics to crystal ball economics.

And therein lies the problem. It seems to me that the more one is separated from actual data, the more shaky the structure becomes. Once you shift the focus away from actual data to predictions about what future data will be, you have started playing a different game, that of appearance and expectations, and this can swiftly spiral out of control, where prices can start to rise based on unrealistic expectations, and then the rise itself seems to retroactively give substance to the expectations, which in turn fuels expectations of even greater rises, which causes even greater price rises, and so on. In short order, one has an accelerating price spiral where the relation of the price to the actual value of the commodity has been severed.

In some cases, fixing the actual value of a commodity is not easy and the price does become the value. This is true where rarity is an important factor is setting the price, such as in gold and precious stones. Art is another such commodity. Clearly the value of a painting by Rembrandt is not based on the raw materials used and the hours he put into its creation.

But apart from such specialized situations, in most situations we do have a rough idea of how much something should rationally be priced at based on some measure of underlying value, such as the cost of raw materials and labor, the cost of similar items in the market, and historical price patterns. When the prices of such things start outstripping the underlying value by wide margins, then we are heading for trouble because of the creation of ‘bubbles’. As Eric Janszen defines it in the February 2008 issue of Harper’s Magazine (p. 39): “A financial bubble is a market aberration manufactured by government, finance, and industry, a shared speculative hallucination and then a crash, followed by depression. . .A better, if ungainly, descriptor would be “asset-price hyperinflation” – the huge spike in asset prices that results from a perverse self-reinforcing belief system, a fog that clouds the judgment of all but the most aware participants in the market. Asset hyperinflation starts at a certain stage of market development under just the right conditions. The bubble is the result of that financial madness, seen only when the fog rolls away.”

The most famous historical example of a bubble (perhaps because it seems so extreme now) was the tulip bulb craze of 1636 where the price of tulip bulb ‘futures’ (i.e., the price expected in the future) skyrocketed, with reports of a single bulb selling for as much as a fashionable house and garden in Amsterdam! The problem with such bubbles is that they are like a Ponzi scheme in which the really savvy investors who get in early make a lot of money. The later people make money only as long as the prices keep rising rapidly because of the arrival of new investors (also known as ‘suckers’) willing to buy at inflated prices, thinking that prices will continue to rise. The need to maintain the illusion of unstoppable growth makes people reluctant to prick the bubble by bringing it into contact with reality, by asking awkward questions about the actual value of the commodities being bought and sold. But of course, rapid price increases are unsustainable and it is only a matter of time before the madness passes. In the tulip bulb bubble, by 1637 people started realizing that these tulip bulb prices were unrealistic and that they had been had. The tulip bulb market then came crashing to the ground, and people left holding these future contracts took a devastating financial hit.

The South Sea bubble that crashed in 1720 was another example of where stock prices rose wildly, and the rise itself fueled expectations of future rises, thus leading to an out-of-control spiral, again followed by a crash.

The Florida real estate boom and bust of 1926 was yet another example of a bubble where land prices sometimes quadrupled in a single year, driven up by speculators and naïve investors who felt that the only way prices could go was up and were thus willing to pay almost anything thinking they could make a future profit.

Next: More recent bubbles

POST SCRIPT: Mythbusting the Canadian health care system

One of the big propaganda efforts in the US has been the way the Canadian single payer health care system is falsely denigrated in order to perpetuate the lie that the US has the Best Health Care System in the World, when in actual fact it is bloated, expensive, wasteful, inefficient, inadequate, and corrupt. (See here for a series of posts on health care.)

Here is the first part of a series that combats the myths about the Canadian system.

Comments

  1. Rian says

    In large part, bubbles form in stock prices because the amount of money chasing a single stock far outstrips the actual value of the company. It is not uncommon for even modest mutual funds to have capital holdings running into the billions if not tens of billions. The reason? Not only speculation, but the rise of IRAs.

    There simply are a whole lot of older people that have to individually speculate on the stock market rather than have their employer do it for them in this day of multiple careers in a working lifetime. That’s a stupendous amount of money thrown into the hands of professional money managers rather than corporate pension funds.

    Few companies are worth tens of billions of dollars, and there are a lot more moderate-sized mutual funds with reserves that large. When you have a lot of money chasing not a lot of things (in this case, stocks), then the prices increase. A net effect of that is that the shareholders now drive the process in the ways that you describe, only they’re institutions who have as their sole function to make money for their own shareholders.

  2. says

    “tulip bulb case”? I can’t believe that people would place the future value of flowers over the value of houses… You are absolutely correct though, people will pay crazy prices when they think that prices wont go down, like in your Florida example. I saw similar things in Las Vegas in 2005-6 and people are paying for it now!

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