About a Bubble, Part-1

When I visited Dhaka this September, the city was buzzing with stock (and land) tips. The economy was growing and almost everyone I knew had money tied up in the stock market. The housing bubble in the US was still fresh in my brain, so naturally my first thought was “bubble”, but everyone was so happy, and making so much money. Who was I to spoil their fun? Moreover, there weren’t any obvious signs of a catastrophic failure. You see having lived through the Dhaka Stock Exchange (DSE) crash of the mid 90s, the dot com bust, and the housing bust, I have learned to identify a few indicators of an imminent crash. Nonetheless, the purpose of my trip was to complete a web project for a US Telecom firm and of course to spend time with family and friends; I wasn’t about to pull out data and analyze trends or follow the writing on the wall.

Let P/E be your Guide: One of the most tried and tested ways of knowing when you have a bubble is by tracking the price-earnings ratio (P/E) of investments. If prices are not reflective of earnings you most likely have bubble on your hands. Price of any investment should always reflect its expected earnings. In each past bubble I have experienced, prices had been driven up by over enthusiastic markets and had little to do with expected or actual earnings. During the housing bubble in the US the price of properties were significantly higher than the price reflective of the potential rental income from those properties. This holds true in Dhaka today, which makes me think that there is a housing bubble lurking in the shadows in Dhaka. The rapid urbanization and the hoards of developers who are perpetually tearing down houses and building condos are feeding the beast.

Experts and insider: Given that the market forces are driven by expectations and human behavior, it is good practice to keep an eye out for experts crying “wolf” or in this case “bubble”. There are always insiders and experts commenting on the market’s growth rate being unsustainable in the long run well ahead of the mainstream’s acceptance of the existence of a bubble (thereby bursting it). The ideas of these experts and insiders are slowly adopted by more and more investors, who then take action i.e. sell their investments. Geoffrey A. Moore in his book Crossing the Chasm talks about the technology adoption lifecycle for high tech products e.g. the i-Phone a few years ago, the VCR in the early eighties.

Source: http://mitpress.mit.edu/books/NORVH/chapter2.html

Crossing the Chasm is closely related to the technology adoption lifecycle with its five segments: Innovators, Early Adopters, Early Majority, Late Majority and Laggards. According to Moore, the most difficult step is making the transition between Early Adopters and Early Majority. I happen to believe that the technology adoption lifecycle holds true for the “marketing” of the belief in a bubble. The experts and insiders are like the Innovators and Early Adopters, they are very close to the action and they recognize a bubble early. As more and more investors listen to the experts and insiders they form an Early Majority and take action. Then the Late Majority followed by the Laggards, notice the market trend and dump their investments to cut their losses. Demand gets the rug pulled out from under it and there is an excess of investment products (stocks, properties etc.) causing the price to drop very rapidly.