Revisiting the anatomy of a bubble



Jeremy Grantham’s recent play, Let the wild ruckus begin, argued that the United States is in its 4th “superbubble” in the past 100 years and is in its final stages. This inspired us to refresh our bubble framework (below, taken from our 2017 blog post). Many US stock market valuation metrics are near all-time highs, and with the Fed poised to tighten monetary policy, investors should understandably be skeptical of US equity allocations.

We are heavily influenced by the work of Charles Kindleberger and Hymen Minsky at Variant Perception, and have devoted much of our work to understanding how boom and bust cycles progress.

In Kindleberger’s classic, Panics, manias and crashesit expands on earlier work by Minsky in Stabilize an unstable economy. They found that no two bubbles are the same, but they all share a common structure. Below we have summarized the five key stages of market bubbles that allow you to identify them as they occur.

  1. Shift:

The bubbles start with a displacement, a sort of shock to the system. A displacement can be a war (usually the end of a war), a major political change, deregulation, technological innovation, financial innovation or a change in monetary policy. Displacement creates new opportunity in at least one sector of the economy. One example is the widespread adoption of computers, the Internet, and email in the United States in the 1990s, which paved the way for the dot-com bubble.

  1. Boom:

A boom begins, especially in the favored sector, as optimism grows. There is a positive feedback loop as the price of stocks, one or more commodities and/or real estate increases, which then leads to greater consumption and investment, which leads to a greater economic growth. Credit fuels the boom. Borrowers are becoming more willing to take on debt and lenders are increasingly willing to provide riskier loans as the economic outlook improves.

This credit expansion is not necessarily provided by the banks. The 1636 Tulip Mania in Holland, for example, was fueled by funding from bulb sellers. However, banks have been the main source of credit since the 19th century. Banks can expand credit further and faster than sellers could. To make matters worse, new banks are often formed in the expanding economy. This leads banks to further relax their credit standards to avoid losing market share.

  1. Euphoria:

A boom turns into euphoria as “rational exuberance turns into irrational exuberance”. There are hundreds of books documenting the endless possibilities of economics (e.g. Japan as number one and The East Asian Miracle in Japan in the 1980s, and Dow 40,000 in 1999). Participants extrapolate recent price increases into the future, expecting prices to continue to rise at unsustainable rates. Some, especially industry insiders, realize there is a bubble, but many continue to participate in the market, believing they can sell to the “biggest fool” before the implosion.

However, more euphoric foreigners are beginning to enter the market as media attention increases and individuals see others getting richer. As Kindleberger quoted in Manias, panics and crashes, “there is nothing more troubling to one’s well-being and judgment than to see a friend get rich.” The rush of capital causes prices to rise again and healthy investments turn into wild speculation. Individuals invest in the hope of short-term capital gains, and debt mounts as people borrow or trade on margin to speculate further. Money seems free. Fraud is also common at this stage, although it is usually not revealed until later.

  1. Distress:

At some point, an event occurs that causes a drop in confidence and a pause in the explosive rise in prices. The event can be a bankruptcy, a change in government policy, news (real or supposed) or a flow of funds from the country. The response to these events differs in bubbles due to debt accumulation. People who have financed their purchases with borrowed money become distressed sellers when the income from their assets falls below their interest payments. Kindleberger noted, “The economic situation of a country after several years of bubble-like behavior resembles that of a youngster on a bicycle; the rider must maintain momentum or the bike becomes unstable.

A slowing bicycle is actually a better metaphor than a bubble. Sometimes panic sets in immediately, but in other cases it can take up to several years for the crisis to fully develop. In the dot-com crisis, the panic happened almost immediately, whereas it took a few months for the panic to set in during the Great Financial Crisis.

  1. Panic:

Not everyone realizes that a crisis is unfolding at the same time. Insiders and institutional investors usually sell first. Once other market participants realize the seriousness of the situation (perhaps after another major event), the banal sell-off turns into outright panic as everyone tries to get out at once. Prices are falling and indebted companies are increasingly bankrupt because they cannot pay their interest. The liquidation generally extends to other sectors and to other countries. As bankruptcies increase, banks may begin to fail, further drying up credit when it’s needed most. The panic continues until a lender of last resort convinces investors that cash will be made available to meet demand, or prices fall so low that value-oriented investors begin to redeem.

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