finance – Andrew E. Scott

Thoughts on a Tech Bubble

I have been trying to get to grips with the meaning of investment “bubbles” for a couple of years now (for instance in this blog post about tulip mania). I first started to look into this during the local property boom when I was also studying finance. However, there’s increasing talk online of whether we are now in some sort of tech bubble, akin to what happened around the years 1999-2000 and resulted in the dot-com crash.

I wouldn’t say that I have a mature position yet on bubbles, but I think I know enough to say that we’re not in a tech bubble. At least, not yet.

One problem with a test for a bubble is that it is difficult to know for sure that you’re in one until after they’re over. For one sure sign of a bubble is that it ends in a crash – the bubble pops. At this point, prices of the investments in question drop quickly, and many people lose a fortune.

Other signs of a bubble, such as speculative investors (people investing because they expect prices to go up due to investor behavior not necessarily due to increase in underlying worth) or dodgy investments are present in most markets most of the time, and shouldn’t be a concern of themselves. You would hope that in a market there are a variety of positions being taken on investments for a variety of reasons, and that new investments can be introduced into a market if there is a demand for them.

Also, many markets are naturally cyclical, with regular booms following busts over time. Just because a market is hot doesn’t mean it’s in a bubble, although it probably means prices are higher than otherwise warranted, in which case you’re unlikely to pick up a bargain. But people investing for the long-term with diversification across different markets can typically ride-out a cyclical decline.

That said, the first reason I don’t believe we are in a tech bubble is that currently a decline in the value of tech start-ups wouldn’t result in the average punter losing a fortune, because the average punter is not able to invest in tech start-ups. We’re not in a situation, like back in 2000, where an ordinary investor can invest in the latest crazy tech stock on the NASDAQ. It is really VCs and Angels who are taking the risks right now. So, we can’t yet experience the sort of widespread disaster that characterizes a crash.

The other reason I don’t think even the keen anticipation for the Facebook IPO could make this a bubble is that a bubble is a description of a market and not a single investment. You can’t really talk of a 13 Pearl St Essendon bubble or an Enron bubble (even while their stock did crash and wipe many people out). We would need to see average people investing in a variety of new tech companies for there to be a bubble in the tech market.

But there may be signs that this could yet occur. Services like Kickstarter and IndieGoGo have sprung up that allow everyday people to pledge or commit money to a cause, which might be to bring a product or service to market. If causes start to take on more investment characteristics, this begins to look like a means for early stage investment in tech companies.

If I start to hear about people extending the mortgages on their homes to put funds into Kickstarter projects, I will be worried that we’re in a bubble, but I’m not worried yet.

Perhaps there was no Tulip bubble

I’ve been trying to understand what a financial bubble really means, and in the course of this, came across some interesting information: apparently the great Dutch Tulip bubble of the 1630s wasn’t a bubble after all. Although I am wary to merely summarise stuff that is written better elsewhere, I thought this was a good one to share.

Background

Tulips came to the Netherlands from Turkey in the 1500s, and became a popular status symbol. Multicoloured varieties were produced due to the effects of a plant-specific virus, and as a result (skipping the details), it would take at least seven years after planting the bulb of a spectacular tulip to produce new tulips from it. Understandably, possessing a spectacular tulip bulb gave you an advantage for quite a period of time before others could gain a similar bulb.

Due to rising prices, speculators entered the tulip market in 1634, and a more formal futures market in bulbs arose in 1636. By some accounts, offers for single bulbs reached insane levels, e.g. 49,000 m^2 of land for a bulb. In February 1637, the price of tulips crashed. For the next few centuries, “tulip mania” is used as a textbook example of crazy market behaviour with a boom and bust.

Why not a bubble?

If a bubble is where markets are caught up in “irrational exuberance”, then it appears that this market continued to be rational. And if a bubble is where a market eventually “pops” and the resulting crash causes widespread losses, then it appears that losses were not significant. Of course, it is hard to know for sure, since all of this happened almost four centuries ago, but there is apparently some evidence that:

In February 1637, the futures contracts all became options contracts, i.e. the purchaser of a contract to buy bulbs no longer had the obligation to purchase or take delivery of the bulbs if it looked like they would make a loss.
This change was known to be coming from several months beforehand, encouraging purchasers of contracts to agree to high bulb prices with minimal risk. Taking this perspective, the contracts were rationally priced.
Actual tulip prices (as opposed to the price of these futures contracts) remained at ordinary levels.
The Dutch authorities halted the trade in the contracts, and later decreed them unenforceable gambling debts. So, given that no tulips changed hands that winter (as the tulips would’ve all been in the ground) and the contracts were unenforceable, it’s not clear that there were any significant losses made.
Most of the support for claims of a tulip bubble come from some anti-speculation propaganda published soon afterwards.

Perhaps, then, there was no Tulip bubble. I guess all those textbooks need updating.

How the 80s became the naughties

One of the defining events of the naughties – the first decade of this millennium – was the global financial crisis. How mortgage defaults in a few US states, leveraged many times over through the global financial system, brought about a crash in the world’s stock markets and a world-wide recession. But its genesis was in 1980s Wall Street as chronicled by ex-Salomon Brothers employee Michael Lewis.

Liar’s Poker

Vulgar, incredible and fascinating take on 1980s finance

I listened to the audio book earlier this year, and Lewis’ tale blew my mind. Here was a person who, by rights, should not have been in that place at that time, as he didn’t have the traditional qualifications to get a job trading at Salomon Brothers, nor did he even interview for the job. Furthermore, instead of continuing to make wads of money, he chose to quit and write an account of it. Lastly, it was written well in a very accessible style. The chance of all these things happening must have been minuscule – and yet they did.

If Lewis is to be believed, and he presents himself credibly, Wall Street in the 80s was inhabited by a bunch of racist, chauvinist cowboys who through luck more than wisdom and possessing a complete disregard for their customers managed to make out like bandits. This is, of course, completely counter to the image that Wall Street projects of itself to its customers.

The story is part-memoir, part-history and part-ethnography. The author’s prior education was in art history, and second career was in journalism, and he picks out the threads that led to the particular situation that he was dropped into, as well as charting his progress through the firm and documenting its culture. It is a unique book, and truly fascinating, even if you don’t have a background in finance let alone the bond market.

My rating: 4.5 stars

Liar’s Poker

First-hand account of Wall Street’s cowboy culture and the rise of mortgage bonds

Most recently, Kate gave me a paper copy of Liar’s Poker, given how much I enjoyed the audio book. I quickly discovered that it was a rather different book.

Liar’s Poker was Lewis’ first book, and the text really does feel like it. For example, paragraphs feel like they are crammed full of information. In the audio version this wasn’t so obvious. Also, there is a great deal of background, historical information in the middle of the book, which I found bogging down the interesting personal tale, and much of which was excised from the audio book version. The book would’ve benefited from more aggressive editing, and the audio book, being an abridged version, had effectively received this.

That said, it remains a compelling tale. All of the aspects that I liked in the audio book version, I still found in the paper version, although it was less focussed. Perhaps if another reader hadn’t experienced the audio book first, there wouldn’t have been an expectation of a fast pace already set.

My rating: 3.5 stars

Too-Big-To-Fail Considered Harmful

On 15th September 2008, the Lehman Brothers investment bank filed for bankruptcy protection. Their shares fell 90% that day, and the assets of the company were later scattered between Barclays and Nomura and some other smaller entities, according to Wikipedia’s article on the company. It had grown from its founding in 1850 to assets of US$639b, making it the biggest bankruptcy in US history.

That a company so big was allowed to fail shocked the financial services industry, and the global financial crisis shifted up a notch. Within a week, the two largest US investment banks (Goldman Sachs and Morgan Stanley) had turned themselves into banks with greater access to Federal Reserve funding. From what I can tell, no company that large was allowed to fail again during the global financial crisis.

There was talk that many such companies were “too big to fail”: that the repercussions to the economy and society if they failed would be so dire that governments would step in to save them. This is a troubling notion, and there is clear moral hazard where the sole reason to stop a company failing is that it is “too big”.

The principle of entrepreneurs taking on risky ventues, and being rewarded if they succeed, is a basic one in a capitalist society. However, if there is no chance of failure when a venture gains a certain size, then there is an incentive to create unsustainable growth until that size is reached, when rewards will be obtained at no risk. Or, to put it another way, the government of the day chooses to take all the risk for companies with the riskiest behaviour. This is clearly not something in either the economy’s or society’s interest.

Alternatively, if a large company was discovered to be following illegal business practices, under the rule of “too big to fail”, a regulator would not step in and take action against the company, because it would put the company at risk of failing. This isn’t a good idea either.

So, if propping up a big, failing company is a bad notion, what are the alternatives? Well, the obvious one is to let them fail. Obviously there are also the options of either making them smaller (e.g. split them up) or stop them getting big in the first place.

That said, big companies may be propped up if there are reasons for it other than their size. Letting all of Iceland’s major banks fail hasn’t done it any favours. Still, in Australia, if CBA, NAB, WBC or ANZ failed, I’m not sure what we’d do.

Actuaries as Heroes

One of the troubles with an insight is that when you then explain it to someone else, they find it obvious. It can be a bit disheartening, but people seem to have a knack for finding surprises obvious in hindsight. Which, of course, doesn’t make them any less of a surprise at the time.

So, coming across a book that points out that stuff that I take for granted was not taken for granted 500 years back, and in fact, enabled civilisation as we know it today to flourish, I was a bit surprised, you might say. It was interesting to try to put myself in the position of people who didn’t know about probability, to see how something so “obvious” could be an exciting insight.

Against the Gods: The Remarkable Story of Risk

An interesting journey through the birth and history of risk management

The author, Peter L Bernstein, puts his main thesis plainly enough at the start – “The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.” However, it’s a good thesis, is extensively researched, and Bernstein writes about it well. Enough to sustain interest over some 330 pages.

I found it quite compelling to think that, before the Renaissance, people thought of the future as something they couldn’t control, only put up with. And, that God or the Fates dictated what would happen, or tomorrow would simply be same as today, and it was egotistical or heretical to try. This assumption closed down any thought of trying to build a science of probability, so until the assumption was broken, we couldn’t develop probability, statistics, or insurance.

Marine insurance was needed to make European colonisation economically feasible. Life insurance was sold by governments needing to raise funds to wage wars. Risk management is used by organisations to manage large projects. Home or health insurance are regularly used by prudent families to protect against disasters. Society would be a lot smaller, simpler and sadder without this elementary mathematical invention. Yes, actuaries are heroes.

Bernstein drew me into the successive insights produced by keen minds over the recent centuries that has taken us to where we are today in economics, finance and gambling. Some of the people he profiled were more interesting than others (but others may have their own favourites) – the initial Renaissance thinkers and the behavioural finance guys were pretty cool. It would seem to be a rather complete set of the important contributors.

If you have any interest in modern history, economics or mathematics, you’ll probably find this book a worthwhile read. And it also made me reflect on what other basic assumptions we might hold that could be overturned in order to advance society.

My rating: 4.0 stars

Can you wire me some money?

PayPal (now owned by eBay) has made a mint from mashing up the concepts of money and communications. Originally they were about allowing you to email currency to whoever you wished, debited out of your credit card. These days, they offer a large number of related payment services, similar to other financial companies. However, I find it interesting to consider how similar the businesses of finance and telecommunications are to each other.

Coming from a telecomms background, I am most aware of that side of the fence. Telcos (and cellcos and cablecos etc.) offer credit or store a monetary balance for customers, and support very large volumes of real-time transactions, settling amongst multiple similar companies both nationally and overseas. They also send out bill statements, take money on behalf of others (e.g. when you make a 1-900 call), are highly regulated, and for some reason, no one trusts them. But apart from the operational and customer interface aspects of telcos having similarities to financial companies, there is another important aspect.

Both financial companies and telcos have a facilitating role in society and the economy. If either the financial system or the telecommunication networks collapsed tomorrow, it would be no exaggeration to say that civilisation as we know it would be threatened. However, of themselves, both of these industries do not actually generate the basic goods and services that we consider to make up our civilisation, whether they are music, news stories, furniture, clothing, food, or housing (to name a few). Some may be as harsh as to call these industries parasitic rather than facilitating.

Financial companies have their business in money, while telcos have their business in communication. Each of these simple concepts can be broken down into three main sub-components.

Money is not merely the notes and coins in your wallet. A monetary transaction is a combination of an amount (measured in terms such as US dollars, or grams of gold), a time period (measured in anything from seconds to years), and a risk (which is often not easily measured at all). These sub-components are not independent, and may not even have a single value. For example, your brother may be giving you $10 next week, but he may turn out to only give you $5 and owe you another $5 for the week after, or perhaps the full $10 may never appear. If you’ve ever calculated a NPV (Net Present Value) then you have attempted to incorporate amount, time and risk into a single number, although it is difficult to do this accurately for any but the simplest scenarios.

Similarly, I see a communication having three components, being distance, latency and fidelity. (This differs from the standard theoretical approach to defining a communications channel according to bit-rate, error-rate and latency, but this is too narrow for my purposes here.) A telco enables you to engage in a communication with one or more people, where you get to share some message or receive them from others. You could do this without a telco or technological assistance, but it would need to be face-to-face with the others. So, the first thing a telco enables is communication at a distance, perhaps within your city, or perhaps overseas. Telcos also, by necessity, introduce a certain amount of latency, perhaps less than 1 second, or perhaps several days if you end up leaving your message on someone’s voicemail. Lastly, telcos will provide a different level of fidelity than your average face-to-face conversation, where the communication could be only one-direction at a time versus bi-directional, there may be drop-outs, or the quality of the communication could be impaired through loss of high-frequencies or introduction of noise artifacts. As with the sub-components of money, the sub-components of communication are not independent, e.g. if the communication is occurring on a digital channel, then the bandwidth of the channel will most likely affect both latency and fidelity.

So, both finance companies and telcos deal in complex, multi-dimensional products (money and communication). And both improve the quality of life we experience, facilitating many of the things we do in society.