If you follow the financial news, market bubbles seem to be boiling up everywhere: Hedge fund managers, talking heads on CNBC – even Donald Trump sees bubbles.
There are bubbly stock markets: India, Brazil, and the U.S. are mentioned. Lots of bond bubbles: U.S. Treasuries, U.S. corporate bonds, global bonds in general, subprime auto bonds.
There’s evidence of real estate bubbles around the world: Vancouver, Auckland, Sydney, Toronto, San Francisco and London, for starters. There’s a reported bubble in “nine-figure real estate listings.”
Chinese bubbles are a class of their own: Real estate, iron ore, cotton, garlic, eggs and soybean meal are some recent ones. Of course, China’s stock market bubble burst last summer.
Then there is discussion of “the mother of all bubbles” also known as “the everything bubble,” which infers that a global debt bubble feeds all the other bubbles. With so many bubbles, it’s hard to keep track.
Possibly a Bubble ETF (my proposed ticker symbol: POP) is needed, composed of the many bubble markets, so that there’s an efficient way to track and trade the world of bubbles.
Yet, despite the fact that speculative bubbles are popping up everywhere, it can often be hard to tell you’re in a bubble until it pops. It would help to know how to tell a bubble is forming.
Luckily there are about four centuries’ worth of speculative bubbles to study for answers.
The first widely known and the most famous market bubble of all time was Tulip Mania, which occurred in Holland in the early 17th century. The Dutch became enamored with tulips that had flaming colours on their petals. They coveted the bulbs that grew into these unique tulips.
As demand for the bulbs increased, along with their value, a market in tulip bulbs developed. As word of profitable speculation spread, more people piled in. Prices moved continuously higher.
Then from December 1636 to February 1637, the price of premium tulips surged by 200 percent. At the height of the mania in 1637, the market price of a single prized bulb was sufficient to purchase one of the grandest homes on the most fashionable canal in Amsterdam – when that city’s homes were among the most expensive in the world.
Needless to say, these prices were not an accurate reflection of the true value of a tulip bulb. In February 1637, buying tipped over into selling, and a domino effect of cascading lower and lower prices took hold. Speculators saw that they had spent vast sums to buy plants that were little more than glorified onions, and liquidated their tulip bulb holdings without regard for price. As wealth evaporated, pandemonium engulfed Holland. A deep economic depression followed.
Tulip mania established a pattern that has since been repeated over and over in speculative bubbles ever since. Despite advances in economic theory and the increasing sophistication of markets, market bubbles, and human psychology, haven’t changed much since the 1630s.
In 2008, Jean-Paul Rodrigue, a Canadian transportation scholar, conducted a study of the history of bubbles, and published a model of bubble stages:
1. Stealth Phase. The initial bubble stage is where a new market opportunity, or paradigm, is cautiously recognised by early smart money investors.
2. Awareness Phase. As market prices rise, more investors are attracted to the new investment story. The media begins to cover the story, adding to the momentum, and investors become increasingly interested – and increasingly less sophisticated.
3. Mania Phase. Now everyone notices the rising prices. The media is touting “the investment of a lifetime.” Price becomes detached from underlying economic reality. Euphoric, irrational investors project recent price gains into the future. Enthusiasm spreads like a contagion between investors. A feedback loop ensues – rising prices amplify stories that seem to justify high valuations, which attract an ever increasing number of buyers.
Even cynical traders join the buying, expecting to sell to “greater fools.” Price gains become nearly parabolic. Paper fortunes are made. Greed rules. Meanwhile the smart money is selling to the dumb money.
4. Blow-off Phase. At some point buying abates and a paradigm shift slowly – or sometimes quickly – unfolds, as market participants realise something has changed. Sellers now find few buyers and prices fall quickly. Leveraged speculators face margin calls and are forced to sell. The decline becomes a crash.
Everyone now views the market as “a house of cards,” and prices plummet at a rate much faster than when the bubble was inflated. Often, prices fall below pre-bubble levels. The market becomes universally hated. But eventually the smart money starts buying again, recognising the panic has created an opportunity to buy assets at bargain prices.
For instance, at the beginning of 2013, you could buy one bitcoin for about US$12. By the end of November, you could have sold it for US$1,100 – a 9,000 percent gain. When the bubble popped, bitcoin prices fell over 50 percent within a month.
As shown below, in 2013 bitcoin went through all the phases of a classic market bubble.
Another example is the Shanghai Composite index just last year. Starting in August 2014, the index gained 125 percent in 10 months. This was fueled in part by easier margin lending rules, which allowed Chinese investors to borrow more to invest.
This amplified the speculation and buying, so prices kept going higher. Thinking that buying stocks was an easy way to make money, less sophisticated investors entered the market and mania ensued.
But eventually the bubble popped. Investors realised stocks were way overvalued and the market collapsed and fell 32 percent in less than a month.
Over 400 years of market bubbles have shown a recurring pattern: A smart investment idea gains a following, and prices rise. The media discovers the story, ever more investors join in, becoming increasingly excited, and prices rise even more. Valuations lose connection with economic reality. Sooner or later the bubble bursts, prices crash, and many investors are ruined.
With potential bubbles in so many different markets across the globe, it’s a good time to study this historical pattern. Knowing what stage a market bubble is in can help you avoid taking a bath when the bubble pops. And bubbles always pop.