What is a financial bubble? How does it evolve? How can we protect ourselves from a bubble? I will try to answer these questions in this post, as this subject is always relevant but somewhat more relevant today when some assets are being traded near all-time high levels.
A financial bubble (or economic bubble) happens when the price (e.g., market value) of an asset greatly exceeds its fundamental value, which is the value according to standard economic methods of valuation, such as DCF, multiples, and comparable (spoke about it here). For example, if a company is traded at a price of 30X its earnings while other companies in this industry are traded at 20X their earnings, the company is overvalued (unless there is a very good reason, such as massive growth or one-time expenses), but if all the companies in the same industry are traded at a multiple of 30X while in the past they were traded at a much lower multiple, then we might see a bubble. There could always be “extenuating circumstances,” e.g., a small sample, a dramatic change in the industry or in the market, lower interest rates, but dramatic change requires a thorough evaluation.
If it happens to one stock, the industry overall would not necessarily be affected, but if it happens to all the stocks related to a major sector or to the lion’s share of stocks in the market, we might be seeing a bubble.
The history of bubbles
The first modern bubble was the tulip mania. In the early seventeenth century, the Netherlands had the strongest economy worldwide, and Amsterdam was the financial capital of the world. The first stock exchange as well as the first futures market were established in Amsterdam, and one product that was available for trading was contract prices for bulbs of tulips.
Tulips were brought from Turkey at the end of the sixteenth century. After being damaged by disease, the supply of tulips started to decrease, thus yielding higher prices. Rising prices effectively introduced this market to people looking to gain high returns. The market exploded with traders and speculators, and prices skyrocketed. Problems started when some people were looking to limit their risk and take profits—a domino effect that led to a lower price accompanied by a large number of sellers. The market panicked, and eventually the price of tulips crashed.
This bubble did not have a major effect on the world economy, but it was the first notable instance of the dynamics of a financial bubble—an asset’s price starts to rise, leading people to buy the asset without determining the value of the asset (or sometimes even understanding it). Then the price continues to rise, and the more sophisticated traders (those who actually evaluate the asset) or those who hate risk begin to sell the asset. The price starts to fall, and the rest is history—panic, crash, and a lot of lost wealth.
The first really harmful bubble was the South Sea bubble, which affected Great Britain, the greatest economic power in the world at the time.
The South Sea Company was a British company founded in 1711 with one major purpose—reduce the cost of the national debt. The company barely used the monopoly grant it received to trade with South America but still attracted investors to buy its stock. The company constantly issued stock, convincing the public that trading with Latin countries was the new bonanza. In real life, the company was much better at marketing than generating actual revenue. The successful run of stock led to a new wave of IPOs, as several other companies understood that they could raise money in the market quite easily.
Similar to the tulip mania, problems started when some investors wanted out. This time it was the company’s management who understood that the value of the stock was far above the real value of the company. They started to sell their stock, rumor spread, and panic ruled the market. Several other companies sold innovative ideas related to the new economy, and trading with the colonies collapsed. The British government had to take action to stabilize the banking system. Afterward, it was forbidden to issue stock in Britain for another century!
A few other crashes occurred at various times before the great one in 1929, which led to the Great Depression and World War II. After the Americans had been victorious in World War I, the U.S. economy accelerated rapidly, and most of the Western world became very prosperous. In the 1920s, the stock market overcame many obstacles, and this euphoria attracted many people (lacking any financial understanding whatsoever) to the market, pouring all their savings into stocks, assuming that the market would only go up. Again, the phenomenon was used by sophisticated traders who manipulated stock prices and sold overpriced stock.
The belief that the stock market would continue to rise forever collided with reality in 1929. The American economy showed early signs of a recession, and some economists’ warnings became reality in October of that year, when panic hit the street. The Dow Jones plummeted dramatically and lost a double-digit percent of its value in consecutive days. Some $25 billion—$319 billion in today’s dollars—was lost in the 1929 crash. The stock market returned to its pre-crash numbers only in 1954.
The stock market has experienced several crashes since—Black Monday in 1987, when the Dow Jones fell by 22% in one trading day; the Dot-com Bubble, when many technology and Internet companies collapsed after years of unrestrained growth; and the Subprime crisis, the most dramatic crash since 1929, as the real estate bubble almost led to economic catastrophe worldwide.
How bubbles evolve
Financial bubbles differ in their origin and circumstances leading to an explosion, but they do have many similarities. Most bubbles are created when people invest in an asset they don’t understand very well. Therefore, bubbles are usually created with newer assets. For instance, the dot-com bubble was related to astronomical valuations for Internet companies, and the Subprime bubble is related to a new financial instrument that aimed to insure banks from lending high-risk mortgages. Even the tulip mania started when the Netherlands started to import tulip bulbs from Turkey.
As new technology by itself is not a bad thing and the world economy sees new developments all the time, the similarity that really intensifies the possibility of a bubble is when the market starts to be crowded with unsophisticated investors. When professionals are successful enough to attract average people with promises of easy money, then a bubble could be triggered because the asset’s price loses correlation with the real value of the price. The market can easily behave as a pyramid scheme where those on top ultimately stay happy.
Sophisticated people who try to sell the asset are not always lying. Sometimes, they actually believe in what they are saying. They think that this time it will be different since the technology is innovative, and the market is different. Essentially, it’s always easier to join the big crowd and not be the one who shouts about the emperor’s new clothes. Furthermore, the financial industry works on commissions and profit share by nature, so gambling against the market trend can be costly in the short term and can actually get you fired.
Professor Robert Shiller sums it well, “Big things happen if someone invents the right story and promulgates it.” Thus, newer products are prone to yield a bubble if they have good marketing people working for them.
How do we identify a bubble?
Not all bubbles are identifiable before the burst, and not all appreciation in asset prices is a true sign of a bubble, but some bubbles can be identified (even if there is no real treatment) based on analyzing the situation:
- Dramatic changes in price—do not necessarily mean that it’s a bubble, as the rise in the price of some assets can be easily explained by economic methodology, but it’s definitely worth keeping an eye on.
- Changes in a key parameter of the market, such as specific ratio (as I wrote here regarding price-to-income and other affordability measures)—if the number of companies trading multiples is much higher than what it used to be or if real estate prices are pricier in comparison with income, then we can start checking more deeply.
- More debt—when people are using credit to buy assets, it’s usually a sign that they think the price will continue to rise and therefore are willing to take a risk. When a bank or other institution gives them credit, it’s also a sign that the bank anticipates that the price will continue to rise, especially when it’s a nonrecourse loan, which is a loan where the collateral is the property (this is what happened in the Subprime crisis).
- A lower interest rate environment, which encourages borrowing money and inflates asset prices.
All these examples are signs of a bubble, but they are also signs of unhealthy economic behavior that can be fixed with a small correction in the market. Not all price spikes end with a burst.
What happens when a bubble bursts?
The effect of a bubble bursting varies between the asset and its effect on the economy. While the tulip mania did not have any effect on most people in the world, the bubble bursts in the last hundred years had a great impact on most people, as the world became more globalized and connected. When we are referring to bubble burst, we are talking mostly about notable ones, particularly those that happened in America, while in real life bubbles can occur everywhere and all the time. Bubbles can evolve everywhere when it seems possible to make money easily, but most of these bubbles do not have any global impact.
A global bubble burst can destroy a large amount of wealth and cause a GDP decrease, higher unemployment rates, higher debts for both public and private sectors, and financial instability. Bubble bursts usually lower spending and consumption, as the fall in the value of their houses or stocks makes people feel less rich.
Are financial bubbles avoidable?
Most economists believe that bubbles cannot be identified in advance and cannot be prevented from happening. Moreover, some believe that attempts to intentionally blow the bubble can cause greater damage than by letting it burst naturally.
Economic research suggests that bubbles are prone to evolve when interest rates are low and cheap loans are readily available that people can use to buy risky and volatile assets. Sound familiar?
Most of today’s assets enjoy almost a decade of cheap credit. The stock market, the housing market, and the bond market (not to mention cryptocurrencies) all experienced a great increase in their prices in this period, and there is strong controversy among economists about whether or not we are currently in a bubble. I do not believe the prices are inflated to the extent of a bubble, but I do believe that according to most economic measures some degree of correction is needed in most markets.
Not all assets are necessarily correlated, and you need to find an umbrella in case of a wet period; thus, the best advice as always is to diversify your portfolio. As good as this advice is on normal days, it is even more useful when the bulls become bears.