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

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

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.

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.

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

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