A cut-out-and-keep guide to bubbles

One theory held by some market strategists is that a tidal wave of cheap cash, provided by central banks’ interest rates and Quantitative Easing (QE) policies, means we are witnessing ‘The Bubble of Everything’ as prices surge across a range of assets, spanning from equities to bonds, to property, to art, wine, sports cars, thoroughbreds… You name it.

It’s a beguiling theory but spotting a bubble is not as easy as it sounds. Fed chair Ben S. Bernanke flatly denied that the US housing market was in a bubble in the middle of the last decade, only for it to blow up in his face shortly afterwards and – perhaps most famously of all – the economist Irving Fisher argued in mid-October 1929 that “Stock prices have reached what looks like a permanently high plateau,” only for the Black Monday Crash to follow just a fortnight later.

It may therefore be worth revisiting this column’s preferred text on the topic of bubbles – Charles P. Kindleberger’s Manias, Panics & Crashes – to identify the sequence of events that can be seen through the history of previous market crazes, ranging from the South Sea Bubble of 1720 through to British canals (1790s), Latin American mines (1820s), US equities (1920s), Japanese equities and property (1980s) and global technology stocks (1990s), to name but a few.

Been there, seen that

Technology stocks were the first really big bubble of this column’s financial market career, which began in 1991. This can be seen from the below chart of the NASDAQ Composite, which went parabolic in 1998–2000 but then fell so heavily that it wiped out four years of gains in half that time, subsequently taking more than a decade to reach its prior highs.

Source: Refinitiv data

This decade has seen a sequence of such episodes in quick succession as, flushed by cheap liquidity and driven by the search for yield and returns superior to those offered by cash, markets have proved increasingly bubbly. A broad list includes:

  • Chinese equities in 2014–15

  • Source: Refinitiv data

  • Bitcoin in 2017–18

  • Source: Refinitiv data

  • Cannabis and marijuana stocks in 2019, a fad which is already leaving many portfolio builders with burnt fingers

  • Source: Refinitiv data

    Looking at the patterns of past bubbles may help advisers and clients duck the next disaster which will, inevitably, unfold at some stage.

    Bubble check-list

    This is because the details may change from bubble to bubble, but human behaviour clearly does not, and the running order is pretty consistent.

  • The starting point for a bubble is a new investment opportunity, one that may be genuine or even one with just a big enough grain of truth to be irresistible to those looking for a quick financial killing. It could be anything from railways to cryptocurrencies and the more disruptive or revolutionary it seems, the better, as everyone likes to get in on a ‘new paradigm’ and believe that ‘it is different this time’. Don’t they?

  • The initial price rises then catches the attention of newcomers, as ‘fear of missing out’ (FOMO) starts to gather.

  • Investing (and operational) profits go into orbit and fresh cash is attracted, often in the form of borrowed cash. (One oddity of the current passion for firms like Uber, Lyft and Peloton is they don’t even make a profit themselves.)

  • More copycats and imitators spring up and more credit is made available as asset prices keep running and the profits keep flowing.

  • Then the trouble starts. Insiders start to lock in their profits by selling to the unwary at elevated prices and leave investors holding the bag. Prices initially correct but then rally as loyal supporters ‘buy on the dips’.

  • Initial signs of distress then start to sow real seeds of doubt. A new offering goes wrong, a firm runs out of cash and asset prices fail to reach their previous peaks. The queue of copycat flotations and management teams looking to sell their stock on a secondary basis gets longer by the minute and the supply of paper begins to outstrip demand.

  • Then comes a good, old-fashioned scandal. Someone goes bust, or accounts prove to be crooked, or someone runs off with the money and investors realize they have been had.

  • Fear and revulsion replace greed, asset prices collapse as investors scramble to cut their losses and the recriminations begin as scapegoats are sought and publicly pilloried (or worse). Ironically, this stage may be the one where there are bargains to be had and real profits to be made, assuming the bubble’s underlying concept was sound in the first place.

  • Advisers and clients can now judge for themselves where they feel they stand across any asset class they care to consider. Perhaps the easiest signal to follow is the emergence of copycat flotations or multiple versions of the same fund, active or passive, promising access to a hot new theme. The experiences of cannabis stocks in 2019 certainly suggest as much and, with that in mind, this column will be interested to see how many products and collectives with an environmental, social and governance (ESG) theme launch in the coming months, alongside any which specialise in electric vehicles, even if it is still very early days for both.

    AJ Bell Investment Director

    Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.