Just as I began writing this, I came across an article by Martin Wolf in The Financial Times. He, for one, is not convinced that stock markets are in a bubble. Provided corporate earnings are strong and interest rates ultra-low, stock prices look reasonable.
Cliff Asness once remarked that the term bubble “should indicate a price that no reasonable future outcome can justify”.
So I thought it best to refer to the experts. In Manias, Panics and Crashes, Charles Kindleberger outlines the five phases of a bubble.
Phase I: Displacement
All bubbles start with some basis in reality. An event or innovation or disruption that sharply changes expectations and generates excitement. Bubbles start with a displacement, a shock to the system, a new opportunity in at least one sector of the economy: end of a war, major political change, deregulation, technological innovation, financial innovation or shift in monetary policy.
An example of disruptive technology is the widespread adoption of computers, the internet and email in the U.S. in the 1990s. This set the stage for the dot-com bubble. A fundamental change in an economy would be the opening up of Russia in the 1990s that led to the 1998 bubble.
Phase II: Boom
The narrative gains traction. Optimism grows. The narrative gets reinforced. The positive feedback loop bids up asset prices (be it stocks, commodities or real estate).
Loose credit and easy lending fuels the boom. Borrowers become more willing to take on debt and lenders are increasingly willing to make riskier loans as economic prospects improve.
The Tulip Mania in 1636 in Holland was fuelled by vendor-financing from bulb sellers. In the 1920s in the U.S., people believed that technology like refrigerators, cars, planes, and the radio would change the world. To finance all the new consumer goods, installment lending was widely adopted, allowing people to buy more than they would have previously. In the 1990s, it was the Internet. Companies resorted to vendor financing with cheap money that financial markets were throwing at Internet companies. In the housing boom in the 2000s, rising house prices and looser credit allowed more and more people access to credit.
Phase III: Euphoria
Individuals extrapolate recent price increases into the future, expecting prices to continue to increase at unsustainable rates.
As the social media attention grows and people see their neighbours and aunts make money, the fear of missing out (FOMO) throws caution to the wind. As Kindleberger says, “there is nothing as disturbing to one’s well-being and judgment as to see a friend get rich.” Some realize that there is a bubble but continue to participate believing they can sell in time. Debt compounds as people borrow or trade on margin to further speculate.
(Robert Shiller echoes the identical sentiment in Irrational Exuberance: I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.)
The general perception is that it is easy to make a quick buck. Day trading is perceived to be more lucrative than the regular day job. Euphoria makes people think the good times will last forever, or at least for a long time and they will be well aware as to when to exit.
Phase IV: Crisis
Distress sets in. The selling begins. As the selling gains momentum, the speculators too latch on.
It could be an event that causes a decline in confidence or a pause in the explosive momentum. A bankruptcy, a change in government policy, a piece of news (real or rumoured), or a flow of funds from the country.
Phase V: Revulsion
Euphoric buying has given way to panic selling. The bubble has burst. Greed has given way to fear. The contagion of bad news has changed the narrative. Things will never get better. The sky has fallen.
Everyone tries to sell at the same time. Prices plummet to irrationally low levels. Leveraged companies begin to go bankrupt. The sell-off spreads to other sectors. Bankruptcies mount. Credit dries up.
Is it time for the bubble to burst?
While each bubble may have its own distinguishing characteristics, the key ingredients are a confluence of numerous factors: Innovation or the perception of it, speculative leverage, and the emotion and psychology of investors – collective delusion.
The crash will happen. It always does. History is a prescient guide because human nature does not change. The question is when?
Howard Marks has often commented that cycles occur with regularity throughout history even if one is unable to pinpoint exactly when they will come.
The truth is that one can never know how long each phase will last. As George Soros said in an interview in August this year, “the stock market's rally is trapped in a Federal Reserve-formed liquidity bubble”. As there are no laws of nature or physics at work, there’s no telling how long this liquidity-fuelled rally will last.
I resort to quoting Shiller again: Those who predict avalanches look at snowfall patterns and temperature patterns over long periods of time before an actual avalanche event, even though they know that there may be no sudden change in these patterns at the time of an avalanche. It may never be possible to say why an actual avalanche occurred at the precise moment that it did. It is the same with the stock market and other speculative markets.
Have I answered the query? No. But it is no stretch of imagination to see that we are right now in Phase III. And before I proceed to venture any more guesses, I am reminded of John Bogle’s “Nobody knows Nothing”.
Investment Involves Risk of Loss.
