On bubble ripples and avoidable struggles

(written in 2008-04 on the tulip craze in reference to the subprime mess; relevant to this bitcoin stampede?)

Tulipomania by Mike Dash, is a fascinating story of the Tulip; how it propagated through the centuries from its natural setting in the rough wilderness of the steppes of western and central Asia to the manicured gardens and exquisite corsets of the highest courts of Europe. We learn that throughout this journey, the tulip was ironically the host of a virus that caused specimens, once broken, to produce flamboyant characteristics that would be passed on to its offspring; we also learn about the other “virus” it carried: the one that infected societies and inflamed spirits and minds in the Dutch republic and the Ottoman Empire. The tulip’s adventure is interesting for its historic significance alone; this is however a reflection on the role it played in triggering destructive human behavior. We will look at other events where collective and individual human weaknesses caused the proverbial inflationary valuation bubble, and the inevitable and damaging subsequent crash. We will ponder on the DNA of this recurrent disease that ruined the life of countless innocents in past centuries; we will also attempt to identify early signs of the pathology, and possible paths to build up personal immunity and resistance.

Bubble Gum 

It is fair to say that most boys born in America in the latter part of the last century have come in contact with some form of collectible sport memorabilia. When I was a kid, we collected and traded hockey cards. These were by then not packaged with gum, as an afterthought: they were a full fledged product on their own.  In the somewhat closed universe of my primary school, these held much value. Later, in my early years of high school, this fact was reinforced when we found out that some adult collectors where in the business of buying and selling them.  At what we later perceived was the height of a growing frenzy (and coincidently was the height of my interest for the trade), Wayne Gretzky himself bought an exceedingly rare mint card for half a million dollars: Bobby Orr rookie in Topps, if I recall correctly.  Around that time, anybody’s claim that John Leclair’s rookie card was not worth much more than the paper it was printed on would have been met with by my best smile, and the question would have fused right away about whether the claimant’s stash was close by and if he’d be interested in parting with anything.  

A monthly “independent” publication called Beckett’s was the Bible in pricing matters.  When the magazine failed to get published for 2 months because the publishing house was bankrupt (most probably because of decisions based on market expansion that did not materialize), a keen spectator might have gotten a clue that something was not quite right. When even complete neophytes about hockey and the collectibles where getting in the trade because the 12-card Upperdeck set that sold for 2 bucks at the corner store most likely held double of that in value once unwrapped, alarm bells should have started to ring: a bubble was forming; someone would soon get gum on his nose. When the card companies started introducing collectible cards with cartoon comics and tennis players anybody in his right mind should have seen through the ever thinning surface.

As was alluded to previously, yours truly was lucky enough to lose interest at what later became a high in the local frenzy. I departed with my most prized possessions when their price was optimal and there was a big market for cash sales. A brand new pair of hockey gloves, a pair of fluo sunglasses was the loot the author got out of his adventure in lala-land of mass-produced collectible trading. Mass-produced collectibles—no, no, it’s not a contradiction.

A small community of hardcore collectors were instrumental in helping these companies create a market that robbed a lot of young boys of their pocket change. How did they do it? One method was artificially pumping up the market by making items rare; another method is by closing the loop, in getting hockey players themselves to buy and hold the collectibles: they closed the referential loop and artificial value was thus created. One should keep an eye out for this insidious pattern. 

Pink Tulips

Our ancestors exchanged vast swathes of land for mirrors: an uneducated uniformed chump getting fooled out of his valuable possessions is hardly more than a historical footnote. We can imagine in the course of history a myriad of different settings where the common saying‘s fool and his money were soon parted.  Let’s now consider the case of the collective madness where average weavers in 17^th century Holland exchanged the tools providing their families’ sustenance for some fifty aces of a prized bulb and half a pound of switzers.What would make someone act with such blind foolishness? What conditions create a frenzy where market laws are suspended and price inflation starts to defy gravity before coming down in a mighty crash?  Can it be explained away by greed and the search for the greater fool? Is the beginning of this search the dying canary of the impeding catastrophe? What are the conditions for emergence of a bubble and the events that point to imminent disaster? 

We cannot try to answer all these questions here as there seems to be material for a much longer essay, but we’ll aim at choosing a path that might lead to a better understanding of the pathology.

The tulip market was an existing connoisseurs’ market before the tulip trade came in full swing, as it is described in Tulipomania. This is also a precondition of the hockey cards mania. The rarity of the “broken” tulip varieties was not artificial, as the (then unknown) virus was not easily propagated. Tulips took several years to produce flowers from a seed, which then needed to be “broken”. The “breaking” process was irregular. Bulbs unpredictably produced a very limited quantity of offsets. This also happened in the card trading example; mint condition 1958 Topps cards were in short supply simply because they were of little worth when they were first introduced, and most people threw them away over the years. The same phenomenon happened in the stamp collector’s market; interestingly enough, there is no recorded bubble in stamp value although it’s a rather universal activity. Stamp collecting and numismatics are examples of connoisseurs’ markets where rarity is the value driver (the most valuable stamps are the low number runs with print errors). They however seem to contain systems that prevent the formation of bubbles. Interestingly enough, they both have another era’s useful valuation printed right on them. 

As noted earlier in the sports card example, the bubble trouble starts when neophytes are suddenly introduced en masse in an existing market. It has been often noted that the collective intellect of a group is significantly lower than that of its members. This depends on known features of the human psyche: we generally are conformists and enjoy sticking with people that share our opinion. We also easily defer to “expert” opinion, mostly out of conformism, but also out of intellectual laziness. These are not all weaknesses, but combined they can cause the emergence of a herd mentality. A leaderless herd better not be too close to a cliff; when we are aware that this herd is ridding up a hill we should remember that everything that goes up must eventually come down.

Aeron-Firesale.com

Never attribute to malice that which can be adequately explained by stupidity. When an average person becomes convinced that they can make an easy buck by sharing the good news about a great new trade with theirs social network and getting someone else onboard, insidious schemes develop-no malice required. Malice however is involved in engineered variants of these social cancers; all pyramidal and Ponzi schemes were started by very mischievous individuals that sometime end up in jail, rightfully. If you’ve ever attended a “wonderful-once-in-a-lifetime” time-sharing opportunity group meeting during a vacation in Florida or in Puerto Vallarta, you’ll have witnessed how clever sales people actually take advantage of the gullibility of crowds. The masterful artifice of group dynamics deployed to bring the human mind to embrace such concepts must be absolutely staggering. This brings us to another key point: greed and the profits from the trading business.

All bubbles have in common the implicit idea of an exuberant neophyte launching a new business that will automatically generate handsome profits. Conducting successful business activity, let alone the trading business, is only given to as select few:  80% of startups fail in the first 5 years. There is no such thing as a free lunch. One should be wary of easy money with low barriers to entries capital wise and no barriers to entry knowledge wise. Seasoned investors and businessmen often fail in new ventures; it’s not for the faint hearted, and definitely not for the average Joe. The arrival of a mass of such ill-informed participants is common of such bubbles. It’s also true of the dotcom stock bubble. (think of soccer moms and the waiter of your favorite restaurant speculating on e*trade.com) This was also true of the often forgotten stock price run up that preceded the 1929 crash. A lot of common people’s assets were wiped out while still holding stocks they were not equipped to value properly. Stock prices took a full 27 years to recover from the ensuing 80% drop in value- a sobering thought.

Bubbles that start on an underlying economic trend, such as the dotcom bubble, are really dangerous. As they inflate it becomes harder for the critical mind to differentiate fact from fiction. Once influential individuals buy in the collective hysteria, the reference loops gets closed and the herd‘s bandwagon becomes a self-fulfilling prophecy. It was called a new economy. Right!-no profits, just crazy valuations, amazing growth plans by young MBAs full of self-entitlement, and fancy office furniture- sure sounds like a great plan.

This era’s folly and excess is embodied in an interesting way by the Aeron chair. Retailing at over 1000$ for the fully loaded version, these Herman Miller creations where the dotcoms’ symbol of democratization of the workspace. Almost all dotcom had them, along with the espresso machines and foosball tables. These chairs were the icon of an era, a statement about a paradigm shift: running shoes-clad visionaries throwing away the cubicle and suits of corporate America.

 There is even the story of a late dotcom startup that, upon raising 3 million$ in a second round of financing, immediately went out and spend half of it on 100 chairs for employees  working on foldable tables setup in a warehouse. They were out of business six months later. With that type of business acumen they assuredly would have been wiped out, even without the bubble’s implosion. How they ever got that passed investors is beyond anyone in his right mind. 

Here’s an eerie and ironic coincidence: the chair was manufactured at a plant in Holland Michigan, just north of Tulip City Airport_. 

Bubble (Blood)bath

A bumper sticker seen in Silicon Valley in December 2001 summarizes the subprime fiasco and ongoing bank bloodbath well: “God please give me just one more bubble”. Greed is a feature of humanity. The unraveling subprime mess is not the last. Retail banks had traditionally been shielded from these by the 1930 Templeton act. This act was lifted in 1999, but was thoroughly violated during the preceding decade as banks were acting more and more as investment outfits. They had their own internal credit risk assessment, and held very close relationships with credit rating agencies that volunteered a friendly nod. Isn’t this obviously a bad plan? The moral of the story seems to be: be weary those long toothed business majors that exhibit low moral standards. They were there during the dotcom crash as well. They can also be infected by herd mentality and there can be compounding effect because they sometimes pose as, or sound like experts.

Here’s a funny coincidence:  January 2000 yours truly would get about 100 spams a day about this hot dotcom stock; clear pump and dump schemes. Then in March it stopped from the day to the next. In October 2006 this flood had restarted at about the same volume of pre-approved low variable-rate mortgage applications. A few months later these new spams had vanished. Somewhere in their cycle, bubbles seem to attract shady characters looking for greater fools. This could also be a valid early warning.

In all these bubbles, we remember an event as the flash point where the bubbling boiling market turned into an all steam affair: Gretzky buying a card for half a mil, or the orphan’s famous estate bulb sale. In the unraveling US housing bubble and subprime mess, the turning point is somewhere at the end of August 2007. Who the actors are is still not too clear, as the dust settles, we’ll see where the responsibility lies. 

Someone playing with fire is bound to get burned: trying to time the bursting point of a bubble is Russian roulette. A lot of house flippers learned that the hard way. 

From Crowd to Herd

If you ask a diverse crowd to estimate the number of gumballs in a gumball machine, the average of all answers will be very close to reality, a lot closer than the large majority of guesses. This concept is called “wisdom of crowds”. This wisdom depends on two things: the diversity of the crowd and the non self-awareness of the crowd. If any of the two is not true, groupthink emerges. Here’s an illustration:

Participants in an experiment are asked to choose a number between 0 and 100 that will be 2/3 of the average of the choices of the others participants. Anyone’s individual basic statistic skills will induce a first step to say that the average should turn out to be 50, so two thirds of that would lead you to guess 33. This is when it gets interesting: if a high majority takes this thinking path, the actual right answer is closer to 22, two thirds of 33. But then more rational elements might take it one step further and guess that a lot of people would take this first step, and guess close to 15, about two thirds of 22. Repeat the experiment a few times with the group and the best guess is zero, as more and more of the participants become somehow aware of the self-referencing quirk happening. The crowd has become a herd.

Let’s imagine another experiment. First, instead of being about an arbitrary pick between 1 and 100, we’ll make the experiment’s contention about what price could command the mint bubblegum wrapper (along with the dried and stale piece of gum-unused-) that accompanied the 1951 Topps Mickey Mantle card. The presentation of the item should vaguely imply that this is a rare item and that some collector might covet it. Our participants are each asked to make a guess about the average price the group would come up with for this item. We’ll add one last twist: we’ll use an inverse fraction. Instead of guessing 2/3 of the average, participants will be asked to guess 6/5, or 120% of the average of the rest of the participants’ guess. Wash, rinse, repeat- you have a bubble in a nutshell. Then after a few rounds, ask the participant that guessed the closest to the actual (now severely inflated) average to buy it for the said price, faking a misunderstanding that the experiment was in fact an auction. When he categorically refuses to pay the by then substantial amount, ask for a bid, any bid. Please, please buy my 50 aces of pink triple A-rated ABCPs. Ouch.

Some thoughts to chew on 

Constant self-examination to determine the color of the glasses one is wearing seems like a good start to steer clear of bubbles. Once determined that one is not wearing the rosy spectacles, a deal too good to be true generally is too good to be true. In the same line of though, a good way to save the piggy bank is to remind oneself how hard and long it is to fill up in the first place. One should also be weary of rarity for rarity’s sake. This type of rarity is a collector’s universe. It is rooted in our brains’ inflamed and feverish “own-stuff-more-stuff” appendix that our conspicuous hyper-consumption society prods and pokes daily.  If this rarity gets out in the open, it becomes a social phenomenon; then price inflation rests on an ever expanding social circle and an ever increasing fever. One should be weary of herds and of groupthink. Mixing exuberance and greed can lead to dangerous hubris and delusion. Remain critical of the opinion of experts by acclamation : “who benefits?” is a great question to ask oneself about statements made by these public figures of authority. Somehow the self-referencing loop might be closing.




Addendum: What about Bitcoin ?

If you're still with me here, thanks for reading this far! 
Can coin mining operations(now LTC?)  be seen as people trying to get in a business that is too easy, like in --you'd be crazy not to? Is the proliferation of alt coins eerily similar to the swtizers and south sea clear pump and dump stocks, or disney characters collectible cards? What is the objective value of a functioning ACH if that's what bitcoin is (say a cooperative version of VISA) -- so mining/commissions should yield the yearly profit of said corporation, if/when it is fully developed, and has completely replaced it? If bitcoin's right first application is cases of hyperinflation, how will it be of any use when the gov shuts down the com links, as was seen recently in the middle east?

Are BTC-E Mtgox true impartial valuators/exchanges if one cannot really take cold hard cash off the table quickly? How about true derivatives?

Cheers, and dont risk money you cant loose.


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