Thursday, November 7, 2013

Manias and Fair Value

The mainstream media coverage of share issues for Facebook and now Twitter has me thinking that one of two things has happened.  First, either it is a very, very slow business news cycle or, second, we have entered yet another stock mania.  My suspicion is that this is yet another mania, created by the "pump and dump" set and heavy coverage by the media.

By way of comparison, let's take a look back at one of the original manias, Holland's tulip mania of the 1630s, also known as "tulipomania".  Tulips were highly sought after by the wealthy in parts of Europe.  By the 1630s, even the middle classes strove to own tulips since they were seen to be an important part of maintaining one's social status.  In Holland, since tulips bloom in mid- to late spring, the buying and selling of tulip bulbs generally occurred during the summer months so that prospective buyers would have a chance to view the flower and have an idea of what they were buying since the value of the bulb varied with the appearance of the flower.  Once the bloom had died, the bulb was removed from the soil.  The problem with this system was that the flower varied from one season to the next.

In 1635, prices for tulip bulbs began to rise and bulbs, rather than being sold individually, were sold by weight while they were still in the ground.  The weight was measured in aasen, a unit of measurement that is less than 0.0017 ounces.  This meant that larger bulbs cost purchasers more than smaller bulbs and since tulip bulbs become heavier after they are in the ground for a period of time, the price of a heavier bulb could increase by 300 to 500 percent even if the price by weight remained the same.  One advantage to the larger bulbs was their increased ability to produce smaller offset, the small bulbs that are attached to the mother bulb.  This also made larger bulbs more valuable.

The most valuable tulips were those with contrasting, variegated markings.  Most desirable were those that had flames of red or purple against a white or yellow background.  This variegation is created by a mosaic virus that is carried by aphids.  Unfortunately, growers had no idea which bulbs would result in these markings and, on top of that, infected bulbs were less likely to produce the smaller offset bulbs since they had been weakened.

In 1635, the price of tulips began to rise.  Purchasers bought their bulbs in the winter, were handed a promissory note and took delivery in the summer, one of the first futures markets.  Buyers promised to pay a specific price for bulbs in the ground at a specific date in the future, speculating that the bulbs would be more valuable in the future at which time the promissory note could be sold to the new buyer in the hope of realizing a quick and risk-free profit.  By the last two months of 1636, speculation was rampant with the price of the most desirable tulips doubling or tripling.  Many speculators suddenly became rich which enticed other speculators who wanted to get in on the party.  Speculators paid for bulbs using cows, land, shops and houses; in one town, a farmhouse was exchanged for three tulip bulbs.  Buyers and sellers automatically assumed that the bulbs could be sold at ever-higher prices.  The trade in tulip bulbs was so lucrative that they were even traded on the Amsterdam Stock Exchange according to some sources while others state that tulip trading was always on the margins of Dutch society.

At its peak, a single tulip bulb weighing 410 aasen (0.7 ounces) sold for 3000 guilders.  This was approximately 20 times the annual salary of a skilled craftsman and, at the time, would have bought eight pigs, four oxen, twelve sheep, twenty-four tons of wheat, two tons of butter, a thousand pounds of cheese and a ship.  The record price for a bulb that was to be split into two was 5200 guilders or 35 times the annual salary of an average Dutch citizen.

The tulip market crashed (as do all manias) in rather spectacular fashion.  At one auction, the "greater fool" did not show up and, bulbs that had been priced at 5000 guilders a few weeks earlier, fell to one hundredth of that amount.  In the end, the promissory notes were deemed valueless and only contracts made after November 1636 were valid; buyers in these contracts would be freed from the contract upon the payment of 10 percent of the contract's value.  The few who had enriched themselves by selling their bulbs at the height of the market stood in sharp contrast to many families who were ruined by their  "investment" in tulipomania, many merchants and noblemen ended up living on the streets as a result of their foolishness.

While I realize that the Facebook and Twitter initial public offerings are somewhat different than tulipomania, there are some parallels.  People are making the assumption that they have to get in on a “good thing” before it is too late. While that may be the case, stock valuation is purely speculative and, most importantly, unlike Google, Apple and Microsoft, for now, they are pretty much offering a single product.  As we all know, consumers are a particularly finicky lot with extremely short attention spans; what is "cool" today, may be "crap" tomorrow a lesson that does seem very hard for humanity to learn.

Apparently, history really does repeat itself and what appears to have value today may be worthless tomorrow.



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  2. This market is all a twitter as we continue in a "greed and stupidity loop." The loop can be explained as follows, stocks are rising so why get out, not getting out is causing the stocks to rise. Yes we are indeed experiencing a double down and let it ride mentality. I don't have to explain the greed part, a perfect example is how Twitter ratcheted upward its IPO price over the last few weeks from the mid teens to $26. People continue to enter the stock market at these nose bleed heights and often at super high multiples in an effort to make money in an economy where few opportunities exist.

    The stupidity part is more interesting to explore, many people have noted the disconnect between Wall Street and the economy yet the market continues to punch out new record highs. The stupidity is that many investors discount the risk or are oblivious to how vulnerable they are to a rapid and massive loss. Anyone highly leveraged and trading on margin will be toast if still in when reality returns, more about this topic in the post below,