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WARREN BUFFETT: The foundation of every market bubble is a 'sound premise'

Sam Ro
·Managing Editor
(Image: Wikimedia Commons)

It starts with a “sound premise.” And then the "price action takes over."

On May 26, 2010, Warren Buffett was interviewed by the Financial Crisis Inquiry Commission (FCIC). In newly released transcripts, we see that the FCIC asked Buffett several questions regarding what he thought caused the housing and credit bubble, which eventually popped and pulled the economy into the worst recession since the Great Depression.

Brad Bondi, then Deputy General Counsel of the FCIC, asked Buffett, “What do you think it was, if you were to point to one of the single driving causes behind this bubble?”

Buffett began his brilliant response by quoting his mentor Benjamin Graham, who also literally wrote the book on security analysis.  Here’s Buffett:

...Ben Graham, made an observation, 50 or so years ago to me that it really stuck in my mind and now I’ve seen evidence of it. He said, "You can get in a whole lot more trouble in investing with a sound premise than with a false premise."

When you have a sound premise, you may also have a “This can’t go wrong” mentality. And when you add money to that equation, the price action quickly takes over.

It happened in 1929 and 2000

As he offered examples, Buffett remembered a study that was published in 1924 that argued stocks always outperformed bonds.

“That became the underlying bulwark for the ‘29 bubble,” Buffett said. “So after a while, the original premise, which becomes sort of the impetus for what later turns out to be a bubble, is forgotten and the price action takes over.“

Again, you start with a sound premise. But when people see the numbers go up, the pile on.

“The Internet was the same thing,” Buffett said. “The Internet was going to change our lives. But it didn’t mean that every company was worth $50 billion that could dream up a prospectus. And the price action becomes so important to people that it takes over the -– it takes over their minds…”


The same thing happened in the housing bubble

“It’s a totally sound premise that houses will become worth more over time because the dollar becomes worth less,” he said. “It isn’t because — you know, construction costs go up.  So it isn’t because houses are so wonderful, it’s because the dollar becomes worth less, and that a house that was bought 40 years ago is worth more today than it was then. And since 66 or 67 percent of the people want to own their own home and because you can borrow money on it and you’re dreaming of buying a home, if you really believe that houses are going to go up in value, you buy one as soon as you can.  And that’s a very sound premise.”

That's how it starts.

"Soon the price action — or at some point the price action takes over, and you want to buy three houses and five houses and you want to buy it with nothing down and you want to agree to payments that you can’t make and all of that sort of thing, because it doesn’t make any difference:  It’s going to be worth more next year," Buffett said.

And it's not just the homebuyers.

"[The] lender feels the same way," he said. "It really doesn’t make a difference if it’s a liar’s loan or you know what I mean?  [Unintelligible] something because even if they have to take it over, it’s going to be worth more next year.  And once that gathers momentum and it gets reinforced by price action and the original premise is forgotten, which it was in 1929.”

The financial crisis triggered by the housing bubble was orders of magnitude worse than past stock market crashes. Buffett articulated:

...the price action becomes so important to people that it takes over the -– it takes over their minds, and because housing was the largest single asset, around $22 trillion or something like that, not above household wealth of $50 trillion or $60 trillion or something like that in the United States.  Such a huge asset.  So understandable to the public -– they might not understand stocks, they might not understand tulip bulbs, but they understood houses and they wanted to buy one anyway and the financing, and you could leverage up to the sky, it created a bubble like we’ve never seen.

Bubbles continue to be obvious only in hindsight, largely because something based on a “sound premise” surely couldn’t be a bubble. Unfortunately in the markets, a premise is sound until it isn’t.

(h/t Fortune and Morgan Housel)

On April 30th, Yahoo Finance will have an exclusive live stream of the Berkshire Hathaway annual meeting. Click here for more information.