How Happy Days Lead to Crazy Ways

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In the summer of 2005, I lived in Orange County, Calif., home to one of the most overblown real estate markets our country has ever seen.

A friend's uncle was the CEO of a local subprime mortgage company that recently had gone public. I asked him a simple question: "Do you think we're in a housing bubble?"

"Bubble!? You've got to be crazy!" he said. "Morgan, let me tell you something. I've been in this business for 20 years, and I've never seen real estate this hot. I've never seen people this excited about buying a home, and I've never seen it this easy for nearly anyone to do it. This is the dawn of new era, not a bubble!"

"Thanks," I said, "you've just confirmed my suspicions."

His company filed for bankruptcy 18 months later.

How on earth did we get here?
We all know what happens when bubbles pop -- recessions, bear markets, torn egos, job losses. But not too much thought goes into how they start. This bubble has claimed its victims. Maybe we can learn from our mistakes and not get suckered into another one. We just need to know what to watch out for.

"It's different this time!"
Sure, a good chunk of economic growth is fueled by innovation, but thinking that a new technology allows you to throw age-old investment theories out the window is a good sign that a bubble has begun. "It's different this time," the theory goes. "Everything you learned in your Finance 101 textbook doesn't apply to this company."

Time out. Bubbles arise in part when investors fail to distinguish between two points: the benefit of a new business and how much cash it'll generate.

Witness the dot-com bubble. Were Amazon (Nasdaq: AMZN  ) and eBay (Nasdaq: EBAY  ) incredible new companies that would change the way we looked at commerce forever? Of course! Were they destined to achieve phenomenal growth in the years to come? No question about it.

So buying their shares at any price would guarantee success? Not even close. But when we get all jazzed-up about innovative companies and watch their share prices balloon skyward, the last thing we wonder is whether we're buying shares on the cheap.

Who wants to spend time figuring out silly things like P/E ratios, or reading a balance sheet? Cash flow? I don't have time for it. This stock is going to the moon!

Sound familiar? You've entered Bubbleland.

There are many companies that will change the world forever, but thinking that buying something at any price is rubbish. Was Michael Jordan a good investment for the Chicago Bulls? Absolutely. Would he have been if he demanded a $1 billion salary? Uh, no. Everything, regardless of prospects, has a price limit.

"Feed me. Feed me!"
Our current real estate bubble wasn't born from snazzy new technology, but from cheap money that led to a price spiral that fed on itself.

Let's say Joe Typical wants to take advantage of new cheap mortgage rates from loan shops like Washington Mutual (NYSE: WM  ) or Thornburg Mortgage (NYSE: TMA  ) . Joe buys a vacation home, and demand like his pushes prices a little higher. Joe's neighbors see prices moving up, and they don't want to be left out of the fun. They buy a new home as well. That pushes prices higher again, which entices Joe's aunt, dentist, and tai chi teacher to get in on the action, too. Before you know it, people who don't know the difference between a mortgage and a game of Russian roulette become real estate tycoons, and a bubble is born.

Thar she blows ...
What's even scarier about bubbles is how quickly they can deflate into "antibubbles." Once sunny-minded investors realize that the latest tech stock won't hit $1 zillion before the year's up, their outlook can grow so dark that even solid blue chips such as Procter & Gamble (NYSE: PG  ) get sold at apocalyptic prices.

When the same investors who couldn't help but leverage up to their eyeballs with bubble-esque investments hunker down and prepare for the worst, the same feeding-on-itself behavior works in reverse, and it can pull the economy into an ugly recession. The bigger the bubble, the harder the landing. As you've read in the papers lately, it's bad news.

Will there be more bubbles? You bet. One thing we know about bubbles: We never learn to avoid them. But before you admit defeat and hopelessly get suckered into the next bubble, remember what Ben Graham said: "You're neither right nor wrong because the crowd agrees with you. You're right because your data and reasoning are right."

For related bubbly Foolishness:


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