The difference between genius and stupidity is that genius has its limits.
– Albert Einstein
Genius is a rising stock market.
– John Kenneth Galbraith
Any plan conceived in moderation must fail when circumstances are set in extremes.
– Prince Metternich
I'm forever blowing bubbles, Pretty bubbles in the air
They fly so high, nearly reach the sky, Then like my dreams they fade and die
Fortune's always hiding, I've looked everywhere
I'm forever blowing bubbles, Pretty bubbles in the air
Humans Never Learn
Financial bubbles happen frequently. In the 1970s, gold went from $35 to $850 before crashing. In the 1980s, the Japanese Nikkei went from 8,000 to 40,000 before losing 80 percent of its value. In the 1990s, the Nasdaq experienced the dot-com bubble and stocks went from 440 to 5,000 before crashing spectacularly in 2000. The Nasdaq lost 80 percent of its value in less than two years. Many housing bubbles over the past decade in the United Kingdom, United States, Ireland, Spain, and Iceland saw house prices go up 200 and even 500 percent and then lose over half their value in real terms.
The U.S. market has had frequent crashes: 1929, 1962, 1987, 1998, 2000, and 2008. Every time, the bubble was driven by different sectors. In 1929, radio stocks were the Internet stocks of their day. In 1962, the electronic sector crashed. The previous year, most electronic stocks had risen 27 percent, with leading technology stocks like Texas Instruments and Polaroid trading at up a crazy 115 times earnings. In 1987, the S&P had risen more than 40 percent in less than a year and over 60 percent in less than two years. In 1998, it was strong expectation on investment opportunities in Russia that collapsed. In 2000, the Internet bubble was so crazy that companies with no earnings and often no real revenues were able to go public, skyrocket, and then crash. Eventually, in all bubbles fundamental values re-assert themselves and markets crash.
Economists and investors have spilled a lot of ink describing bubbles, yet central bankers and investors never seem to learn and people get caught up in them. Peter Bernstein in
Against the Gods states that the evidence "reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty."
What is extraordinary is how much bubbles all look alike. The situations were similar in many ways. In the 1920s, the financial boom was fueled by new technologies such as the radio that supposedly would change the world. In the 1990s, the stock market rose on the rapid adoption of the Internet. Both technologies were going to fundamentally change the world. Stocks like RCA in the 1920s and Yahoo in the 1990s were darlings that went up like rockets. Figure 9.4 plots the two charts against each other. The similarities and timing of market moves are uncanny.
If you look at Figure 9.5, you can see the gold bubble in the 1970s. (Some academics have noted that the surge in gold prices closely followed the increase in inflation in the late 1970s, reflecting its value as a hedge against inflation. When inflation fell in the 1980s, gold prices followed. So it is an open question whether gold in the 1970s should be considered a bubble.)
Fast-forward 10 years, and you can see from Figure 9.6 that the bubble in the Japanese Nikkei looked almost exactly the same.
Anatomy of Bubbles and Crashes
There is no standard definition of a bubble, but all bubbles look alike because they all go through similar phases. The bible on bubbles is
Manias, Panics and Crashes, by Charles Kindleberger. In the book, Kindleberger outlined the five phases of a bubble. He borrowed heavily from the work of the great economist Hyman Minsky. If you look at Figures 9.7 and 9.8 (below), you can see the classic bubble pattern.
(As an aside, all you need to know about the Nobel Prize in Economics is that Minsky, Kindleberger, and Schumpeter did not get one and that Paul Krugman did.)
Stage 1: Displacement
All bubbles start with some basis in reality. Often, it is a new disruptive technology that gets everyone excited, although Kindleberger says it doesn't need to involve technological progress. It could come through a fundamental change in an economy; for example, the opening up of Russia in the 1990s led to the 1998 bubble or in the 2000s interest rates were low and mortgage lenders were able to fund themselves cheaply. In this displacement phase, smart investors notice the changes that are happening and start investing in the industry or country.
Stage 2: Boom
Once a bubble starts, a convincing narrative gains traction and the narrative becomes self-reinforcing. As George Soros observed, fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values. For example, in the 1920s people believed that technology like refrigerators, cars, planes, and the radio would change the world (and they did!). In the 1990s, it was the Internet. One of the keys to any bubble is usually loose credit and lending. To finance all the new consumer goods, in the 1920s installment lending was widely adopted, allowing people to buy more than they would have previously. In the 1990s, 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. And a new financial innovation called securitization developed in the 1990s as a good way to allocate risk and share good returns was perversely twisted into making subprime mortgages acceptable as safe AAA investments.
Stage 3: Euphoria
In the euphoria phase, everyone becomes aware that they can make money by buying stocks in a certain industry or buying houses in certain places. The early investors have made a lot of money, and, in the words of Kindleberger, "there is nothing so disturbing to one's well-being and judgment as to see a friend get rich." Even people who had been on the sidelines start speculating. Shoeshine boys in the 1920s were buying stocks. In the 1990s, doctors and lawyers were day-trading Internet stocks between appointments. In the subprime boom, dozens of channels had programs about people who became house flippers. At the height of the tech bubble, Internet stocks changed hands three times as frequently as other shares.
The euphoria phase of a bubble tends to be steep but so brief that it gives investors almost no chance get out of their positions. As prices rise exponentially, the lopsided speculation leads to a frantic effort of speculators to all sell at the same time.
We know of one hedge fund in 1999 that had made fortunes for its clients investing in legitimate tech stocks. They decided it was a bubble and elected to close down the fund and return the money in the latter part of 1999. It took a year of concerted effort to close all their positions out. While their investors had fabulous returns, this just illustrates that exiting a bubble can be hard even for professionals. And in illiquid markets? Forget about it.
Stage 4: Crisis
In the crisis phase, the insiders originally involved start to sell. For example, loads of dot-com insiders dumped their stocks while retail investors piled into companies that went bust. In the subprime bubble, CEOs of homebuilding companies, executives of mortgage lenders like Angelo Mozillo, and CEOs of Lehman Brothers like Dick Fuld dumped hundreds of millions of dollars of stock. The selling starts to gain momentum, as speculators realize that they need to sell, too. However, once prices start to fall, the stocks or house prices start to crash. The only way to sell is to offer prices at a much lower level. The bubble bursts, and euphoric buying is replaced by panic selling. The panic selling in a bubble is like the
Roadrunner cartoons. The coyote runs over a cliff, keeps running, and suddenly finds that there is nothing under his feet. Crashes are always a reflection of illiquidity in two-sided trading—the inability of sellers to find eager buyers at nearby prices.
Stage 5: Revulsion
Just as prices became wildly out of line during the early stages of a bubble, in the final stage of revulsion, prices overshoot their fundamental values. Where the press used to write only positive stories about the bubble, suddenly journalists uncover fraud, embezzlement, and abuse. Investors who have lost money look for scapegoats and blame others rather than themselves for participating in bubbles. (Who didn't speculate with Internet stocks or houses?) As investors stay away from the bubble, prices can fall to irrationally low levels.
