Dr. O's  Instablog

In this decade, we have had more than our share of big-time booms and busts: the tech bubble, the housing bubble and, this year, what Warren Buffett has called the Treasury bubble.

For some years now, I have been a student of these extreme financial cycles. In the 1980s, I witnessed firsthand the Texas real-estate bubble and covered companies crushed in the junk-bond bubble. I wrote a book about the crash of 1929. And to my terrific shame, at the top of an inflated market, I once paid $50 for a $5 Beanie Baby named Peace.

Karen Blumenthal/The Wall Street Journal

Poor investment: Beanie Baby Peace

In studying what drives bubbles, I've come to believe that they follow fairly regular patterns. If we could learn to recognize these, we might be more astute in reacting and adjusting our own behavior. And even if we can't see beyond the excitement they generate, there are underlying lessons for investors.

 Fertile ground. The biggest bubbles appear to develop during periods of rapid and radical innovation, which may leave us more vulnerable to accepting the bizarre rationalizations that often accompany financial speculation.

In the 1920s, the automobile came into its own, and many homes were wired for electricity. Radio wasn't around at all in 1920; by 1929, it was in one of three households, bringing entertainment, music and headlines to millions. Amid all that, there were two tremendous financial bubbles—the 1925 Florida land grab and the roaring stock market that preceded the crash.

More recently, we have seen a revolution much like radio. When today's college students were born, there was no email, no Internet, no pocket-size cellphones, no DVDS, no BlackBerrys. We watched TV shows on a TV set when they were broadcast. Now we watch them whenever we want, on a computer, an iPod or even a phone.

Amid this kind of revolutionary change, you can see how the imagination might be primed to believe that technology stocks could defy gravity—or, in a similar leap of faith, that home prices could climb forever, or that mortgage loans might never have to be repaid.

Getting onboard. The second, more obvious thing about booms is that lots and lots of people get on board, pushing prices up. Initial skepticism gives way to curiosity and then escalates into a kind of frenzy, a feeling that you may be the only person on the planet who isn't part of the fun, and you'd better scramble to get in.

Consider the recent but underreported bubble in fashion handbags. Maybe you missed it, but until the recession kicked in, handbags were the hottest of fashion accessories, made from ostrich, alligator, buffalo or plain-old patent leather, adorned with studs, zippers or pockets.

They were carried by the most beautiful celebrities and coveted by fashionable women. Designers gave them names like fancy cars—the Uptown, the Downtown, the Mulberry Bayswater and the Hermès Birkin—and price tags in the thousands of dollars.

Between 2003 and 2004, handbag sales rose 26%. Over the next three years, sales grew more slowly, but prices climbed higher and higher. The Travel Goods Association estimates sales reached a peak of $9 billion in 2007, double that of 2001.

Ignoring warnings. As prices climb to eye-popping levels, two more things happen: Some experts insist that this time is different—and virtually all warnings are ignored.

As oil prices climbed past $100 a barrel last year, one analyst predicted they could reach $200. Some experts insisted that housing prices couldn't decline across the board.

And in 2007, the research firm Mintel wrote that handbags would remain "an 'affordable' splurge for the style-conscious woman," and that "$100—or even $150—seems affordable compared with a $650 bag and is downright cheap relative to a $1,500 bag." It predicted sales would grow an additional 25% through 2011. Instead, according to the Travel Goods Association, handbag sales plunged $1.1 billion in 2008.

Warnings about extreme prices are often waved off as pessimism or lost in the morass of information we take in every day, allowing speculation to continue. The Wall Street Journal, for example, reported in 2005 on the dangers of looser mortgage standards and of the explosion in potentially hazardous credit derivatives based on complex financial models that tried to predict the likelihood that certain borrowers would default.

Greed takes over. At some point, the bubble reaches a point that is so ridiculous that greed takes over and all common sense must be suspended to continue the myth.

With Beanie Babies, that moment came for me in a chat with my supplier, who said that many customers were certain that these little stuffed animals would someday cover their children's college education. (Our Peace didn't exactly hold its value: Dozens of similar Beanie Babies were for sale this weekend on eBay, and none seemed to have attracted a single bid.)

In the housing market, the red flag should have been loans made to people who couldn't produce any proof that they could pay for them, or 30-year-loans for homes—or worse, investment properties—with terms that never required the buyer to pay one dime toward principal.

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Agence France-Presse/Getty Images

Market top? A $129,000 crocodile Hermès Birkin handbag from 2007.

In the handbag bubble, the giveaway should have been some of the more atrocious bags themselves. In 2006 and 2007, Chanel and others introduced "naked" handbags. They were immediately deemed hot sellers. But they were nothing more than clear plastic, essentially very expensive shower curtains.

 The after-party. The last typical feature of bubbles is a life lesson in itself: The party may be dangerous, but trying to keep the party going—the after-party, if you will—is what really hurts you. You can never predict when a bubble will actually bust. Some of them can continue for a remarkably long time. But when they do, they almost always do so quickly and dramatically.

It's exactly at that point when those determined to keep the fun going take on the most dangerous risks. It was only after the tech boom started to weaken a few years ago that WorldCom Inc. began to cheat on its accounting to try to prop up it earnings. When Starbucks's same-store sales slipped between 2006 and 2007, it tried to maintain its rapid growth by opening more and more stores—hundreds of which it has since closed. In 2008, retailers continued to count on luxury handbag buyers.

After the fact, there are always more shoes—and purses—to drop. Only some months or years after a bubble bursts do we learn what really happened behind the scenes.

More than three years after the crash of 1929, a Senate investigation unveiled one jaw-dropping misbehavior after another. The head of Chase National Bank had been selling his own bank's stock short while publicly urging others to buy. The former chief of National City Bank—now Citigroup—was secretly receiving a huge annual salary in retirement. Senate investigator Ferdinand Pecora called it "a shocking disclosure of low standards in high places."

The confession of former Nasdaq chairman Bernard Madoff isn't likely to be the only stunning disclosure in this cycle. Others have been charged with running smaller Ponzi schemes, and some charges of corporate malfeasance are likely to surface.

So what does all this mean for us as investors?

In a speculative environment, just about the only ones who profit are short-term traders. The smartest player I knew in Beanie Babies was a neighbor kid who rounded up all the stuffed animals in his house and sold them on the street corner for a profit. If you want to bail out, you have to do so on the way up and not worry about missing the peak.

The so-called Treasury bubble has already abated a bit since Mr. Buffett's warning, as climbing interest rates have pushed Treasury prices down. As the economy recovers, prices could plummet.

During bubbles, it's true that in the short term, those who buy and hold are left holding the (expensive) bag. But that's exactly why we invest for the long term—at least five years and really 10 or 20. If your investing horizon is too short to take the chance, you should avoid taking the risk. The only way to survive financial busts is to hang on long enough to outrun them.

This entry was posted by FT Alphavilleon Tuesday, August 25th, 2009 at 16:06and is filed under Capital markets. Tagged with ben bernanke, federal reserve, mohamed el-erian.