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February, 2018

MARKET MANIAS THEN AND NOW
by LARRY

Most everyone has heard of the real estate bubble whose bursting roughly a decade ago also precipitated vast losses of personal wherewithal for tens of millions of Americans plus an economic and equity meltdown that threatened the entire globe's financial system. That investing mania was typical of several which have occurred over the centuries. The most famous, probably, is the great Tulip Fever that gripped Europe in the early 17th Century. Before the collapse of the tulip market in 1637, a single bulb of a certain variety could cost over ten times the annual pay for a skilled Dutch craftsman or in other instances as much as twelve acres of fertile land.

Another notorious instance of market mania involved the British South Sea Company. Its history is complicated but involves a scheme to pay off a large amount of Britain's debt, government corruption, talking up in all quarters a fraudulent, fictitious level of basic company value, plus a frantic level of buying that took the price of a single share of almost worthless stock from 100 pounds to over 1000 in a single year, 1720. Eventually, as sooner or later occurs with all market manias, sellers far outnumbered buyers, and a bubble collapse ensued, the price plummeting back that same year to about 100 pounds a share. Along the way, banks which had loaned frenzied speculators money went bankrupt. As notable an intellect as Sir Isaac Newton lost a bundle in the South Sea Company mania, afterward saying he "could calculate the motions of the heavenly bodies but not the madness of the people."



Prior to the Great Depression, so calamitous an event as to inspire some regulatory controls on stock trading, it was common for "investors" to be able to borrow vast sums on very small amounts of actual equity. People might put up 10% in collateral and buy as much as ten times that amount in stock shares, mostly on margin. As markets are prone to go both up and down, this type practice helped lead to several devastating market crashes between the mid-1700s and 1932. Although most people alive today think of the 1929 to 1932 crashes as the worst such events in history, earlier generations had to contend with the bursting of equity bubbles in 1769, 1791, 1796, 1819, 1825, 1837, 1847, 1857, 1866, 1869, 1873, 1882, 1884, 1893, 1896, 1901, and 1907. From 1932 through 1935, however, legislation was passed that for many decades limited the amount of speculation and margin buying possible in our major stock markets. Currently, however, new investment instruments, with huge sums put into highly leveraged derivatives, for example, are again offering speculators and financial institutions plenty of opportunity for risky ventures, some of which could again, as in 2008, threaten our monetary system. In hindsight, many like to paint the 2008-2009 collapse in rosier terms. Realistically, it is hard to overestimate how close we all were to ruin from that relatively recent financial disaster. By both luck and skill regulators, legislators, and executives helped prevent an unprecedented loss in financial liquidity around the world. Even so, few were left untouched by that event, many losing their homes and savings. Globally, multiple trillions of dollars in former value were lost in just a little over one year of financial meltdown.


This then is the background for a consideration of what makes for a mania and whether any of these phenomena are around in modern times.

Manias have several elements. As with tulip bulbs, these are not limited to stock markets:

  • They are not sustainable.

  • Underlying values are low compared with market prices.

  • Like gambling, they attract a lot of speculation (as opposed to investment).

  • Those who buy into them often have unreasonable optimism.

  • They are driven by an urge to follow the herd, before it is too late to still make an easy killing (for if others are getting rich, I must not be left behind).




In recent years, we have seen a few major and minor examples:

Gold - Cost $17 an ounce in 1931, but reached $1895 an ounce on 9/5/2011, though gold is not nearly that useful as an industrial commodity, rising only on speculative concerns, and since has gone down to a more modest $1357, hardly keeping up with inflation since its high. Between 9/5/11 and now, gold has often been much lower, for instance only $1109 an ounce in November, 2015, a 41% discount to the top gold fever level. One lesson of market manias would seem to be that simply waiting, instead of rushing to purchase what the madding crowd is currently into, can pay big dividends.

Cabbage Patch Kids - These dolls were fairly cheap to make and retailed for $25 in the 1980s. As they caught on, however, prices tripled and more. They were going by the end of 1983 for $150 apiece and "uncaring" parents who did not get at least one of the collection for their offspring were treated to a lot of guilt-tripping. If bought in new condition today, they can be obtained for $22 to $32, off roughly 82% from their peak during the Cabbage Patch craze.



VXX - As the stock market began to recover from the 2008-2009 financial debacle, a new hedge developed against the possibility that what goes up must come down, a volatility index. This derivative, VXX being the stock ticker for Barclays plc iPath S&P 500 VIX ST Futures ETN, is supposed to go up when volatility increases in the equities markets, down when they are calmer. The idea is that as markets become more volatile, there is more risk they will not just go a lot higher but also may plummet. So VXX is theoretically seen as a way of protecting against the tendency sooner or later for markets to fall big time. The trouble is that it is most effective only on a short-term basis. Its value tends to go down a lot over time, so it is best bought when one is fairly sure markets are about to crash. Unfortunately, few are great market timers, so for all but the luckiest among us investing in VXX as a long-term proposition is a losing game. Those who were unhappy enough to buy when VXX was at the height of its bubble, in 2009 and held on to their shares, have by now, after several reverse stock splits, lost over 99.96%. Even those who bought more recently, for instance in February, 2016, when it reached $457, have either gotten out at a loss or held on for a 90.0% reduction in their investments.


Pot Stocks - I had not heard of this kind of asset till last month, but believe it is catching on as a new sort of speculation. If unkind, one might be tempted to say investors have smoked some of the source of the profits. However, the purchase of such stocks, whose attraction is that they are in one way or another connected to the increasing trend among states to legalize at least medicinal uses of marijuana, is taking on a bit of a craze aspect perhaps reminiscent of investment in stills, speakeasies, and bootleg whiskey during Prohibition days, anticipating that it would before long become legal to sell and drink the hard stuff again. Now as then, federal government agencies stand instead for law and order and vow to put the full weight of their authority into shutting down and prosecuting violators. Till that changes, can companies that look to make gains on weed sales be into a reasonable business model? Despite a rationale for avoiding them as speculative, pot stocks are often doing well. I do not yet know if they represent a mania, though. Maybe Congress and a new administration will later see things differently, and if so those who got in on the ground floor and held on could look smart in years to come. A couple of the leading pot stocks are Canopy Growth Corp. (TWMJF) and G W Pharmaceuticals (GWPH). TWMJF has been as high as $29.95 or as low as $19.40 in January of this year alone, a 35% drop from its single-month high. GWPH was selling for $38.46 on 3/7/2016 but went for $138.55 on 1/22/2018, a 260% increase in less than two years. Neither company is close to making a profit.


Crypto currencies - Those who have not drunk the Cool-Aid may not agree, but many are now hot to try this promising phenomenon. It may have seemed foolish at first, for, after all, how could one spend his or her gains and where would the purchased assets be put if only online? Nonetheless, for this kind of investment as well the jury might still be out concerning if it is or is not a mania. Each $22 spent on a single bit coin less than 5 years ago is now worth $10,074 (as of 2/15/2018), and at one time could even fetch $13,800 a 62,627% increase. People who got in on the ground floor are supposedly millionaires and even billionaires after putting in only modest sums. Nonetheless, investments are based on a share in profits. Is the interest in bit coins and other crypto currencies due to how much money they offer those who own them and their comparatively greater value compared with, say, the American Dollar, the British Pound, or the European Euro, or is it primarily due to merely the spiking cost of such crypto currencies and the assumption there will be, for awhile at least, enough more buyers than sellers, that the price will keep surging plus the hope one will then get out before enough other people realize there is little basis to the rise other than hype? Advocates might answer that, just as pharmaceutical or biotech companies offer shares in their future profits, on the expectation they will make discoveries through research and development, even though at present their net income has not been realized, so too with crypto currencies whose potential might be as tremendous as the internet itself, the significance of which was greatly underestimated at first. Of course, dot-com companies also had a lot of potential, it was said, but look what happened to them at the end of their bubble. Are there ways to invest in assets with highly uncertain outcomes but a lot of volatility? Yes, certainly, but this usually requires quite a bit more in reserves, to take advantage of the dips, and, as with VXX, there is always the possibility the current dip will be one from which there is little recovery. When the music stops, not everyone will find a profitable place to rest till it might begin again. Meanwhile, new circumstances keep fouling up our plans. On the other hand, when Amazon was just getting started, it likely appeared to many but a foolish venture, and that has not turned out too badly.


What then can we say of the U.S. stock market? Is it in mania territory or are folks rational who have kept pouring trillions of dollars into it in recent months?

Is the current level of price to value sustainable? No. Seldom has the underlying value compared with stock prices been so low. Despite the modest correction of late, average price to earnings, price to book, price to sales, and price to free cash flow are way too high considering the underlying level of profitability of American companies.

Similarly, stocks are on average offering only about a 1.9% annual dividend. Traditionally, 40% of equities' total return comes from their yield. Calculating that out, at best the currently low dividend level suggests a total return for present day buy and hold investors of only about 4.8%, less than a 3% real return if inflation stays at around 2% a year. Further, based on the total U.S. equity market to gross domestic product ratio, stocks are at such a high level relative to productivity that they are likely to lose investors' money in the next few years.



With unemployment near historic lows, wages will be rising, a drag on profits. With added deficits from policies recently implemented, sooner or later the national debt will have to be paid via severe cuts in services and/or added taxes, a drag on consumer spending. With the population aging and not sufficiently replaced by young people or significant immigration, productivity will be declining. With a greater emphasis on tariffs and go-it-alone trade approaches in lieu of international agreements and cooperation, our economy will suffer. All will cut into companies' bottom lines, and stock prices will follow their declines down. What is more, interest rates are rising. In past such environments, stocks have usually fallen, often sharply. If, despite these considerations, investors keep piling into our stock markets, they are doing so irrationally. Their gains will almost certainly be no better than modest over the long haul.

However, bull markets seldom cease simply because they are overvalued. Almost always there is first a catalyst that bursts the bubble. What might it on this occasion and when will it occur? Who knows? It may take a few more years or could happen this week.



Meanwhile, the band keeps playing, and our stocks and 401k accounts keep going up. Even after a briefly scary correction a bit earlier this year, the S&P 500 Index is up 303% since March 9, 2009. Is it not grand?

[Coming next month: Which Assets Are Being Ignored - Definitely NOT in Mania Mode?]



DISCLAIMER

Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)



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