“We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first.”
Extraordinary
Popular Delusions and the Madness of Crowds by Charles MacKay
(1841).
In
the previous post, we learned that Toronto real-estate is increasing – fast and
furious, Vin Diesel style. The price growth year over year was 4 standard
deviations above normal which means it is completely unprecedented in recent
memory. We know that anytime an asset increases more than 2 standard
deviations, something is amiss.
History
does not always repeat itself, but it often rhymes. Whether you are a
homemaker, a baker or a candle stick maker you are likely asking yourself why
on earth are prices increasing at such an exponential rate?
Throughout
history we seem to get caught up in speculative manias whereby logic and common
sense are exchanged with greed and fear.
One of the earliest recorded speculative crazes was the infamous
"tulip mania" in the Netherlands somewhere between 1634-1637. When the tulip was introduced to Europe for
the first time sometime around the 1500's, people were instantly attracted to
its beauty. Let's face it, tulips have massive sex appeal. Professional growers
could manipulate the colours and the tulips were a highly-sought item of the
wealthy.
For
some reason, the entire country became obsessed with tulips. Speculators began to bid up the prices of
tulip bulbs to the point where a very rare single tulip bulb could fetch 100X
the average annual wage of a general labourer. Some people went as far as to
exchange many acres of land for a coveted tulip bulb. People became rich within weeks just for
holding onto a rare tulip bulb as prices skyrocketed. Why work when you can just own some tulip
bulbs and earn several times your weekly wage for doing nothing? At the time,
it seemed to be the rational choice for many people.
Unfortunately,
the party came to an end and many people literally lost their shirts. Prices
collapsed to where they initially started.
Sir
Issac Newton was one of the most influential scientists and thinkers since the
dawn of time. He wrote the book on the laws of motion and gravitational forces
and was a brilliant mathematician. He
was one smart cookie. You likely read about his work at some point in high
school and university. What you likely
did not read was the fact that Sir Newton got caught up in one of the earliest
known stock manias – the South Sea Joint-Stock Company.
Without
a full-blown history lesson, the South Sea Joint-Stock Company was created with
the intention of possessing a monopoly on trade with South America. In reality,
it was nothing more than a poorly planned scheme of trading government
debt. The shares began to climb rapidly
even though the company was not turning much of profit at all. Everyone wanted
in on the action, including smart people like Sir Newton. Apart from a handful of insiders, most people
lost a lot of their wealth.
How
could this happen? How were people so obsessed with something to the point
where they would pay obscene amounts of money for something and then sell it later
for only a fraction of the price? Buy high, sell low?!
There
are multitude of explanations but, if history is any guide, it comes down to
psychology. We are governed by greed and
fear. When we see people making a lot of money very quickly, we want in and we
want in now. No one wants to miss out on the action. We have a fear of missing
out while others are gaining us and we openly regret "not getting in
earlier".
Let's
be honest with each other for a moment; if your good friend bought
shares in a company that made sweaters for kittens and that company's shares
were increasing 30% per year, you would likely ask your friend for some more
information to potentially invest yourself.
Put aside the fact the company's profits were only growing by 4% a year.
Now, if everyone you knew was buying into this company you would be very hard
pressed not to get in on the action. The
media would likely be picking up on this company and there would be news
articles day in and out. Your co-workers
would be talking about it at lunch on an almost daily basis. And, likely, your
family would be pressuring you to get in on the action. Who cares about reading
the financial statements of the company, if the share price is increasing
quickly you must get in like everyone else so you don't miss out! What happened in the last few months will
assuredly happen again in the future.
This company will re-define stock valuations since 4% in profit growth
now means 30% share price growth!
Ludicrous,
is it not?
The
above graph depicts the stages of a speculative mania. The time for each stage
is different, perhaps a few months, perhaps a few years, but the result is
always the same - a return to the mean. Tulips, stocks, gold, oil, Japanese
real-estate, Miami condos, baseball cards, even Beanie Babies, they all follow
a typical pattern. Yes, in case you
forgot, many people got caught up in purchasing those Beanie Babies at several
multiples of its original price as people were desperate to obtain that tulip
bulb, I mean stuff animal, so it can be re-sold again for a higher and higher
price. [In case you're wondering, Beanie
Babies can still be bought today for $10-15, which is the going rate for any
average stuffed animal.]
Look
up any speculative mania in the last 500 years and it pretty much follows the
same pattern.
Can
we predict which stage an asset is in when the masses are completely mesmerized
by it? Not really. No one can with any precision and this blog will not bother
trying. But there are hints that a cycle
has come to or is close to coming to an end.
They are not always clear at first but after the inevitable peak and
decline takes place they become plainly obvious.
Enough
with the foreplay already and let’s get back to Toronto real-estate. Does
Toronto real-estate follow a pattern of expansion, mania, recession and
recovery to the mean? Is it really different this time?
As
this graph eloquently shows, the cycle repeats the same pattern: expansion, mania, recession and recovery. Every single
time house prices reverted to the mean. Look closer and prices went below the mean every single time. There were booms followed by busts and a
return to the mean. If I wasn’t clear
enough, let me repeat again that history has shown that home prices always
returned to the mean. World wars, cold
wars, technological innovations, communism, immigration influxes, political
parties of all stripes, low interest rates, high interest rates, Madonna - it
only had temporary impact and everything reverted to the mean. This is called
"mean reversion".
As
I’m sure you noticed right off the bat, this graph is out of the date. Prices in 2017 are literally off the chart at
over $900,000.00. Will it continue to go
up exponentially? Possible. Will it return to the mean? Your guess is as good
as mine. Can we predict with any certainty where prices are headed? If Sir
Issac Newton couldn’t, it’s highly unlikely that the writer of this blog or
anyone else reading this blog could.
They key take away point is once psychological factors are at play such
as greed, fear, delusion and euphoria, all bets are off.
