Tag Archives: economy

What Do Crashes and Bubbles Have in Common?

Financial Crashes and Bubbles are opposite expressions of how absurd and irrational markets can behave. Markets over-react irrationally, driven by the irrational sentiments of fear and greed. Panic drives the Crashes and over-enthusiasm drives the Bubbles.

As Martin Varsavsky said to Tim O-Reilly at the Web 2.0 Expo:

“Markets are bipolar, and they over-emphasize good times and bad times. […] Entrepreneurs need to distinguish Price and Value […] (and) steer in the middle of the tremendous swings of the Market, which are unreal in both ends.”

As “unreal” as Crashes and Bubbles might be, unfortunately they have a real impact in the economy. Stock market prices, or how much companies are valued, should not worry anyone but investors. The reality is different. Stock prices reflect the expectations of how companies are going to perform in the future, more than how they financially perform now. With stock prices plummeting irrationally driven by fear of crash (not by current performance), companies quickly adjust forecasts and cut investments and jobs.  Companies show investors how well they anticipate to the changing cycle. This is usually rewarded with a 5% price increase as the measures are announced, followed by 15% down once the downturn is confirmed.

Investment cuts have an immediate effect on the forecast of suppliers that in return also cut investment and jobs in a domino effect that extends throughout the value chain. With more unemployment, no industry is safe from reducing forecasts, and the downturn generalizes, bringing even more pessimism to the Markets. A Crash becomes a self-fulfilling prophecy driven by fear.

Bubbles are just the other extreme, where market irrationally foresee (and analyst justify) exaggerated growth, sometimes even infinite. The gains in stock prices only signal to companies that they need to invests more and grow more. And with everybody foreseeing a bright future, everyone spends more, invests more and take more risks to outpace competition and by doing the stock market goes up and up. It is when price-earning ratios reach 20 for a mature industry and 100 to 1000 for the most trendy industries, that one can sense that the bubble is ready to burst.

Market over-reaction and short-term speculation also amplify the drama. A few weeks ago we had a headline in Spanish newspapers with the biggest loss in history of Madrid’s IBEX down 10% in a day. The next trading day, we had a headline with the biggest ever win of IBEX up 10% in a day.

Analyst are quick to explain the crash and predict apocalypse: 1) Seeing Google stock going down, Om Malik writes “The Sky is Falling”  where not only he echoes some analysts concluding that the downturn will hit online ads, but also Om predicts they will find it hard to attract talent!!? 2) TechCrunch on their side echos a VC-rating site that explains that VCs will not make money soon. I wonder why they did not advice it one year ago. It would have been more helpful.

Analysts and economists are great at explaining the future aposteriori (when it is past). At predicting the future apriori (before it happens) they are as accurate as a monkey shooting darts.

Forget analysts, forget economists. Go find the next dream. Hope and work will do.

Bubbles, Recession and Music Industry

Más dura será la caída” is a Spanish saying that could translate “the higher the rise, the harder the fall”.

Economic cycles are a fact acknowledged by economists, that have written a lot about them. Simply google the term and e.g. see the definition from Wikinvest:
“Theoretically, any deviation from average growth is considered an economic cycle, whether growth of GDP, household income, employment rates, etc. In practice, economic cycles are divided into two main categories: booms and recessions. Booms are associated with a strong economy, while recessions are characterized by below-trend economic growth. The National Bureau of Economic Research (NBER) defines economic cycles a bit differently […]it classifies the economy as being in expansion or contraction. […]

The basic idea behind economic cycles is that […] in the long term, the highs and lows average out to form the trend, or average, economic growth rate. This trend growth rate […]has remained relatively steady in the past”

Economists are very good at making predictions a posteriori, and have developed all sort of theories, including: (1) that the government/central banks interventions somehow incentive the creation of cycles, (2) that the stock market anticipates the cycles and can be used to predict them or (3) that consumer expectations are the best indicator of the coming cycle. And many more.

While there is true in these explanations, one important root cause of recession or crisis are bubbles: The bigger the bubble, the sharper the recession.

  • The Internet bubble of the late 90s with dotcom stocks irrationally valued, even with no business case
  • The UMTS license bids in UK and Germany that sent the telecom industry into a severe crisis, after licenses were bought at 6000 Euros per inhabitant!
  • The house market in UK, US or Spain, with valuations that are not sustainable compared to average earnings (see graphic above from the Economist, and guess its projection).

Future expectations are a clear factor in feeding booms and recessions in the cycles. In year 2000 we could read articles in Wired, explaining how the IT revolution had created a source of permanent growth that would end with the cycles. And so Wired predicted that Bill Gates would be the first trillionaire, based on Microsoft Stock continuing its late 90s price surge over twenty years. Similar rationale went into the UMTS licenses, predicting that wireless data and Machine2Machine would increase revenues by orders of magnitude.

So what is the tipping point after which expectations change and so the cycle? Couldn’t have we all kept the faith in IT revolution powers, so that Bill Gates was by now trillionaire? What if investors had kept (more) faith in mobile operators? wouldn’t we have by now wireless connected machines (fridge, microwaves ovens, washing-machines..) everywhere?  What made the bubbles burst?

At some point in time there needs to be some fundamentals to sustain prices and valuations. Whether stocks, spectrum licenses or housing,  an investment needs a return according to its valuation. Big crisis comes when the expectations have irrationally led to high prices/valuations that can not be sustained by fundamentals. Faith is lost and the sharp adjustment comes as a crash, crisis or recession.

Free market and its law of supply and demand are the best invented system to set prices. It only needs healthy competition, transparent information and the assumption that human beings are rational in their decision. The last point is not always obvious.

So what does the Music Industry has to do with all this? Not much, except that they are going through a tough crisis, once their bubble of high prices burst, due to digital distribution. Music was over-priced thanks to the tyranny of physical distribution – CD, vinyls, scarce shelf space -. Adjustment is just coming.