The Bigger They Are, the Harder They Fall

December 3, 2009

It's difficult to determine when investor optimism becomes irrationally exuberant . 

Although bubbles appear obvious in hindsight, when you're in the midst of one, everything feels quite rational. Whether speculating in Florida real estate, Internet stocks, gold, or even tulip bulbs, most participants in the frenzy could recount their financial ruin by saying, "I guess you had to be there."

We've previously noted how ordinary investment data tells us when expectations are too high. During bubbles, prices relative to earnings and expected growth rates are usually elevated. Even with hard-to-value items like gold, quirks in the data raise questions: Why is the price of gold today more than twice the cost of getting gold out of the ground? Why are gold stocks trading at higher valuations than Intel (INTC)? Intel is a near monopoly provider of a key computer component. Intel's products are loaded with intellectual property that's difficult to replicate – the polar opposite of the companies selling commodities. 

We primarily focus on mutual fund investors' collective behavior, based on the recurring pattern of too much money going into areas shortly before they fall.

Sometimes, the data in the bubble can be skewed by the statistics of the time. Bubbles appear rational in the beginning. Usually, there is some legitimate history of wealth creation and a pattern of growth, whether in railroads, radio, the Internet, real estate, etc. 

Bank stocks never really got that expensive in the last boom based on earnings, but the earnings themselves were inflated based on massive profits derived from record mortgage numbers – volume we may never again see adjusted for inflation.

Fund investor behavior is not the only place in which we see "irrational exuberance" near market tops.

Recently I was reviewing skyscraper history, and I noticed something interesting about the dates of some of the world's tallest skyscrapers. General building booms occur at the top of economic booms, and "tallest building" records correlate quite well with stock market peaks.

Record-high buildings are planned during economic expansions, which makes sense, since someone must need that new office space. But giant buildings are not just about economics. Ego also plays a significant role. Since construction costs can increase exponentially beyond a certain height, a luxuriously tall building doesn’t make much sense when compared to a few smaller buildings. The theory is that the mere greatness and attention of such a massively tall building will make up for any shortcomings in the actual economics. Build it and they will come.

These big buildings tend to break ground a few years before the end of the country's stock market run, and often near completion just as the rug is pulled out from under stock investors entirely – often, rather dramatically.

This pattern occurs not only in the U.S., but in other countries as well. In fact, we’re bringing this historical pattern to your attention because one such crash just occurred: the recent Dubai debt crisis.

Dubai is a bubble city. Seemingly overnight, the city transformed from a near vacant stretch of desert into a shiny global city, replete with the following "Oohs" and "Aahhhs":  a tennis court hanging over the edge of a luxury hotel, indoor skiing, even manmade islands shaped like palm fronds and littered with fancy homes. Much of this development was paid for with debt, debt that is now in a perilous state. 

This is not necessarily all bad, which is why investors loaned the creators of Dubai so many billions. After all, Las Vegas was once a strip of undeveloped desert, too. Dubai is a case of too much of a good thing, too soon.

But there is something else built in Dubai that's relevant to our story – the world’s largest building.

Burj Dubai is scheduled to be 2,064 feet of over 160 habitable floors and up to 2,684 feet including the massive spire on top. This mega-building is scheduled to open in January 2010 – just a few short weeks away from the Dubai debt problem. Dubai’s principal stock market crashed 7% in one day last week as economic fears rose over the country's debt burden.

During most of modern stock market history occurring within the last hundred years or so (The Dow was created in 1896, although stocks began trading in 1792,) the market experienced some of its roughest periods during the construction phases of the world's tallest buildings.

Certainly a tallest building must be going up somewhere at any point in time, and there have always been occasional market panics, but the pattern emerging is a bit strong for it to be chalked up to mere coincidence or data mining. Stocks top out around peaks of optimism, and companies hatch big building ideas during optimistic times. Just as startling is the near lack of panic during the periods in between big building construction projects.

Most big buildings take years to get off the ground, and economic optimism usually collapses before the building is complete. Often, tallest buildings go up in clusters right around the boom tops, with little building records for years following the crash. If mere technological advancements were behind big buildings, the distribution would be more spread out, or perhaps tied more closely to engineering innovations.

Here is a chronological list of the tallest buildings in the world, the related stock market, and the economic events that took place around opening day for the super structure:

  1. The Panic of 1873 occurred just as the Equitable Life Building  became the tallest building in the world.
  2. In 1889, the Auditorium Building  was top dog, followed closely by the New York World Building  in 1890. In 1890, falling commodity prices led to tariffs on imported goods and federal government intervention to bolster the silver market. The economy was setting up for even bigger trouble soon.
  3. The Panic of 1893, kicked off by a large railroad’s financial collapse, was the worst since 1873. It was also one year before the tallest building of its time opened, New York City's Manhattan Life Insurance Building.
  4. In 1901, the panic coincided with the Park Row Building  (1899) and Philadelphia City Hall  in 1901, which reigned as the tallest until 1908. The Dow eventually fell about 50% before turning back up in 1903.
  5. The Panic of 1907 took place right before two more giant buildings hit the scene, the Singer Building (1908) and the Metropolitan Life Tower  (1909). The market peaked in 1906 and eventually fell about 50% during the panic.
  6. The Woolworth Building  was completed in 1913, and remained the tallest until 1930. In 1914, world stock exchanges closed for months due to World War I and reopened about 35% lower and a full 50% lower than the previous peak.
  7. The 1929 crash and ensuing Great Depression hit right around the time three big buildings were completed, each of which held the tallest title for a time. 1930 saw 40 Wall Street and the Chrysler Building. The Empire State Building  arrived in 1931. All three buildings were cooked up during the roaring 1920's. 
  8. So big a bust was the Great Depression that it took four decades for another building to break the record. The World Trade Center  opened in 1972, and was followed closely by the Sears Tower in 1974. Of course, stocks peaked in 1973, and it took nearly a decade for the market to move onto new highs.
  9. In 1998, a new record holder opened. Of course, Malaysia's Petronas Twin Towers  was completed a year after the Asian Financial Crisis and during a deep recession.
  10. The recent real estate and credit bubble "cluster" started with Taipei 101  in Taiwan in 2005. While the crash in emerging market stocks occurred quite a few years later, it’s worth noting that the building was increased to record-breaking proportions before construction commenced in 1999, right around the peak in Taiwan stocks, a level we are still under today.
  11. In 2008, the world's tallest building (by roof height), Shanghai World Financial Center in China, opened just in time for the emerging markets crash. 
  12. And of course, the January 2010 opening of Burj Dubai  is looming mere weeks after the Dubai debt panic.

So far the construction of record-breaking buildings has more accurately predicted downturns than economists. Watch the height of top floors to help get out near the top.