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Beanie Babies, Tulip Bulbs and Bitcoins

I’ve repeatedly expressed my concern that the stock market appears overvalued and at risk of a near-term correction, as reflected by the increasing disparity in performance among individual stocks. Coupled with dimming prospects for any meaningful legislation to stimulate economic growth to justify those valuations, something has to give.

That’s why investors should be cautious when contemplating faddish stocks that may be in the eleventh hour of their surge. Rapidly rising prices don’t last forever, and when they run out of steam they can drop just as fast. While some price increases are temporary and are the result of conditions that can be clearly identified and measured, others seem to take on a life of their own for no discernible reason.

During the recent rampage of Hurricane Harvey through Texas, the cost of basic staples such as drinking water and gasoline temporarily skyrocketed, prompting accusations of price gouging by unscrupulous vendors. However, as infuriating as that activity may have been, it’s understandable given the circumstances. As we learned in Econ 101, when the quantity demanded for an item exceeds the quantity supplied, the price goes up.

But sometimes prices soar because of escalating demand for goods even when there is no disruption to the supply chain to disturb the equilibrium between supply and demand. In those cases, the sudden increase in demand is usually attributable to a change in perception regarding the value of the item in question, which in turn can create even more demand, further driving up its perceived value… and so on.

The term “mania” is often used to describe this condition, and it applies just as much to the financial markets today as it did to Beanie Babies in the 1990s or Dutch tulip bulbs in the 1630s.

In all cases, the underlying sequence of events is the same. Rational price discovery gives way to speculation as investors ignore conventional valuation metrics to justify the cost of owning something, which in turn quickly yields to a greed-fueled buying binge that ends with a collapse.

Hard Lessons

Those of us old enough to have been investors 20 years ago can easily recall the mania surrounding the “dot.com” stocks, as fascination over the nascent Internet created unrealistic expectations as to how soon many of those companies would become profitable. Instead of being measured by time-proven metrics such as profitability, new business models were justified by the number of (human) eyeballs attracted to their websites.

Unfortunately, most of those websites lacked a mechanism to readily monetize that browsing activity. Instead, future advertising revenue was viewed as the primary source of eventual profits, but with so much venture capital money available there was little financial motivation for them to find a way to become self-sufficient. And if the VC money eventually ran out, an Initial Public Offering would bail them out.

Surprisingly, that presumptuous business model worked pretty well for several years before the well ran dry. The tech-heavy NASDAQ Composite Index more than tripled in value from 1998 thru 2000, with a price-to-earnings ratio (P/E) of more than 200 times earnings at its peak. The index gave back all of those gains within 18 months, scarring a generation of investors that piled in near the market top (see chart).

After learning the hard way (or so they thought), many of these chastened investors chose the more tangible field of real estate as a less risky way to get rich. Reasoning that properties built out of bricks and mortar could not possibly be subject to the same indulgent whims as a business that exists only in the ether, they quickly piled their money into second homes and beachfront condos to rebuild their recently depleted wealth.

Of course, it was only a few years later that the real estate market crashed proving once again that it is not the underlying asset that is the cause of these investment manias, but the behavior of the people blindly throwing money at them.

You may think we have become far too enlightened as a result of these experiences to let something like that happen again. But this year a similar pattern emerged over the price of Bitcoin, a cryptocurrency that quadrupled in value during the first eight months of 2017 before taking a quick dive in September after China announced a series of restrictions that prohibits the use of Bitcoin as a means of investment capital in that country.

Bitcoin has captured the imagination of investors all over the world due to its scarcity and independence from any central banking institution. However, that same lack of governmental oversight could also prove Bitcoin’s undoing, especially as mounting concerns over cybercrime call into question exactly who will bail out Bitcoin owners if the blockchain technology on which it is based is compromised by hackers.

I still have some beanie babies stored in my basement that I purchased twenty years ago for my kids. They don’t play with them anymore, but my dog loved to carry them around in her mouth. At least somebody found something useful to do with them.

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