I got a great question last week from a subscriber:

Hi Nathan. If you could expand on the case for and the case against us being in a bubble right now and the stock market coming crash. [I] see all the talking heads right now talking about us being in a bubble.

The First Financial Bubble

In 1554, Ogier de Busbecq sent the first tulip seeds to Vienna. Their popularity began in 1593, when Carolus Clusius, a Dutch botanist, planted his collection of tulip bulbs and found they could tolerate harder climate conditions.

Tulips were incredibly popular was because of their intensely saturated petal color. Other flowers weren't able to match their beauty. They also took years to develop from seeds, so they were expensive and eventually became known as a status symbol. They were so popular that the Dutch created a financial market for tulip bulbs.

What happened next is nothing short of astounding.

In 1841, Charles Mackay wrote a book called Extraordinary Popular Delusions and the Madness of Crowds. He documented the first ever financial market bubble: the Dutch tulip bubble.

And bubble it was...

From November 1636 to February 1637, the tulip price index went from virtually nothing to nearly 200.

A sale of 40 tulip bulbs was recorded for 100,000 florins. For reference, a skilled laborer might earn between 150 and 350 florins per year.

Let's put that into context.

If the average household in the US earns $50,000, the adjusted price of that lot of 40 tulips in today's dollars would have between $20 million or $500,000 per tulip.

This may seem like an old story that has no relevance to today, but I disagree. There is a lot we can learn a lot from the Dutch tulip mania. It teaches us a lot about human nature and the madness of crowds. Here are a few warnings.

Warning #1: Increases Will Last Forever

It may seem silly that people would prize tulips so much that they would be willing to exchange 10 years worth of salary to get a single bulb.

Certainly, they didn't value the appearance of a tulip that much. So why would anyone in their right mind do that?

This quote from Mackay's book sums it up well:

Many individuals suddenly became rich. A golden bait hung temptingly out before the people, and, one after the other, they rushed to the tulip marts, like flies around a honey-pot. Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them. -Mackay, 1841

Here, we see the first clear signal that any asset is in a bubble: the expectation that further price increases will last forever. People buy things with the intent to re-sell them later at much higher prices later on.

Lesson #2: Invest, Don't Speculate

Right, Nathan. But what's the point of buying any financial asset. Don't you always intend to sell the asset to someone else later on? How else would you make any money?

A fair point, but there's a difference between pure speculation (buying because you think someone else will pay more for it later) and investing (even if you eventually sell to someone else). To know the difference, here's an easy test.

Would you still be able to make money on this 'investment' if you held it for your entire life?

If the answer is 'No', then you are purely speculating.

If the answer is 'Yes', then you are investing.

An investment is something that you can value based on the merits of the underlying asset itself. You could make money on the asset even if you never sold it.

A stock is such an investment.

Dividend stocks are easiest to 'see' this in action. If you buy shares in Coca-Cola (KO) today, you will most likely earn a growing stream of dividend income for the forseeable future. The only way you would not is if Coca-Cola's profits decline to the extent that they can no longer afford to pay anything. The asset itself generates enough value that you could earn a profit on KO stock without ever selling it to anyone else.

A non-dividend paying stock also has value if it will pay a dividend in the future.

If you bought Amazon (AMZN) today and never sold it, you would be able to build wealth without relying on the market. The basis of that is tied up in the fortuntes of the company itself. At some point, Amazon will run out of high return investment opportunities. When it does, it will pay out huge dividends. And you will earn real cash profits without selling to anyone; and this will happen regardless of the market value of those shares.

Same thing with Berkshire Hathaway (BRK/B), Facebook (FB), Google (GOOGL) or any other non-dividend payer. The basis of value for any business is the cash you can get out (dividends) discounted back to today at some rate.

A stock can still be in a bubble (as we saw in the late 1990s), but - in most cases - these situations occur for companies that have no reasonable prospects for real profits either today or in the future. It can happen for legitimate businesses as well (like the Nifty Fifty in the 1970s), but it is far less common.

If we look at all the massive bubbles in history, they often occur for 'investments' that do not have such ability to generate value. What intrinsic value does a tulip bulb provide? It has no potential for profit unless someone else is willing to pay you more for it in the future. Without a third party, you cannot make money on tulips.

Or Bitcoin.

Just sayin'.

Lesson #3: Bubbles are High Profile

Another clear lesson from the Tulip mania was in just how easy it seemed at the time. Anyone who owned a tulip or two would've been incredibly wealthy. It was a status symbol.

There is no doubt that word traveled fast just how rich people were getting. Tulip farmers were suddenly wealthier than entire towns combined. Stories would've traveled like wildfire; it would've been in the paper. It would've been everywhere.

All great bubbles are fanned by the media and herd mentality. If you want to avoid bubbles, the easiest way to do it is just to look around you and figure out where everyone else is going. And then just don't go there.

Where are you seeing massive media coverage? Where are you hearing about everyone getting rich (and quick)? And what just sounds too good to be true? All those are signs of hype that (probably) won't last much longer.

So, What About the Stock Market?

As you probably gathered from this title, this was Part I. Next week in Part II, we'll look at some of the past market bubbles and what caused them as well as whether today's market shows some of those same signs.

For premium subscribers, I'm going to take things a step further in Part III. I'll update my valuation model for the S&P 500 and tell you where I think (actually, where my data thinks) the market should be trading at based on today's earnings and interest rates.

I hope you have a wonderful Saturday and enjoy the rest of your weekend!

Nathan

DISCLAIMER: This is not investment advice. I'm not recommending that you sell or buy anything. Do your own research before investing. It is risky, you know. I have no position in anything mentioned here (although, I do have some tulips in my front yard). Please read the full disclaimer here.