While there is a lot of evidence that stock markets are simply unpredictable, there are times when prices get a long way out of kilter with any sense of reasonable value. The term used is “bubble”. Bubbles are harder to avoid than might appear. Herd instinct seems to be firmly embedded in the human psyche, and many studies have shown that quite bizarre behaviour can seem “normal” if enough people are doing it and accepting it as such. Also, abnormal market valuations can persist for very long periods of time, and even hardened sceptics can sometimes get worn down when their dire predictions fail to be realised for years on end.
Nevertheless, it is important to try to recognise the characteristics of a bubble in advance, because they invariably are very easy to recognise in hindsight when they burst, and clients can be unforgiving when they get caught.
Bubbles can sometimes be limited to a particular commodity or stock, but can also describe speculative behaviour across wide regions or investment areas. Many bubbles start in small areas and then spread. An example was the mining stock bubble which followed an announcement of a large nickel deposit by Poseiden NL in Australia in 1969. Prior to the announcement, Poseiden had been trading at .80c, and after the announcement the price moved to $12.30. A fifteen times price hike looks impressive, but the bubble had a lot more than that to come. With very scant information provided and considerable uncertainty about the grades and size of reserves, the price ultimately ran to $280 before finally collapsing. At least Poseiden did have a real find, albeit it dramatically over-valued, but as with a typical bubble, contagion soon followed, and companies with nothing more than a location close to Poseiden or deposits that existed only in the Directors’ imaginations, took off. A rumour started that a company called Tasminex had made a discovery at Mount Venn (nothing ever was discovered there) which sent the share price from $2,80 to $3.30 on the day the rumour started, then to $16.80 on the next trading day and finally on to $96 overnight in London.
Tulip mania in Holland in the 17th century is often cited in discussions about bubbles, and it does serve as a great example of just how silly things can get. At the peak, a single tulip bulb traded for 6,700 guilders at a time when 150 guilders was an average annual income.
Characteristic of bubbles
Essential to bubbles is the suspension of disbelief by most participants. There is a failure to recognize that traders are engaged in a speculative exercise in which people pay too much in the hope of passing the commodity quickly on to a greater fool. High turnover is a feature of bubbles which can look similar to a game of “pass the parcel”.
In virtually all cases, a bubble is followed by a spectacular crash in prices. Bubbles burst, they do not slowly deflate. Frequently a lot of collateral damage is involved. When the 1980s Japanese bubble burst, a prolonged period of stagnation for the whole Japanese economy followed. Even now, 20 years after the stock market peak, the Japanese stock market index is only one quarter of its level then. Those who invested at the peak are still at a 75% loss, and are unlikely ever to see a return of the real value of their investments.
Of course more recently, the damage caused by the bursting of the U.S. housing bubble was extensive and severe. Banks and financial institutions throughout the world held hundreds of billions of dollars worth of securities ultimately backed by toxic sub-prime loans, and by the first week of January, 2009, the 12 largest financial institutions in the world had lost half of their value, many businesses went bankrupt and the stability of whole countries and indeed the whole global economy was under threat.
Minsky’s Theory of Financial Instability
Economist Hyman Minsky was Professor of Economics at Washington University. Before his death in 1996, he proposed an unorthodox theory that the causes of financial instability “Stabilizing an Unstable Economy” (1986) centre on speculation and debt. Unsurprisingly, his work has attracted increased interest in recent times.
Five Steps of a Bubble
Minsky identified five stages in a typical bubble cycle – displacement, boom, euphoria, profit taking and panic.
- Displacement: Something new occurs which excites people and captures the imagination. This might be a mining discovery, the introduction of new technology or even a collapse in interest rates that opens up the possibility of making large investments at little cost. In the USA, the rate on federal funds rate moved from 6.5% in May, 2000, to 1% in June, 2003. And the interest rate on 30-year fixed-rate mortgages fell by 2.5 percentage points to historic lows. The possibility of buying a home suddenly appeared real to many who previously could not have considered it, and the ide was seductive. This displacement effect laid the foundation for the housing bubble that followed.
- Boom: After displacement, prices rise; slowly at first, but then more quickly as more and more participants enter the market and participation is validated by the numbers and the early success stories. The boom phase gets underway accompanied by widespread media attention and success by the early players as the “greater fools” to whom increasingly over-priced assets must be passed are to be found in great abundance.The predominant emotion of those rushing in is the fear of missing out on a once-in-a-lifetime opportunity.
- Euphoria: As prices sky-rocket and fortunes are made, abstainers look foolish and conservative. New valuation methods and measures are introduced to justify the relentless price increases. We’ve seen the extremes reached by Poseiden and tulips. In Japan in 1989, land in Tokyo changed hands for $139,000 per square foot; $14 million for an area the size of a small bedroom.
- Profit Taking: This period has been described as being like riding a tiger; exciting, dangerous and living in the hope that you can get off before you’re eaten. The smart money starts selling down. But no-one can know exactly when a bubble will burst, and once confidence begins to fail and euphoria gives way to fear, the collapse is usually very quick.
- Panic: When panic sets in asset prices plummet, margin calls are widespread, buyers disappear and investors want to, or have to, liquidate at any price. Supply overwhelms demand.
In the single month of October 2008, weeks after Lehman Brothers declared bankruptcy and Fannie Mae, Freddie Mac and AIG almost collapsed, global equity markets lost a staggering $9.3 trillion of 22% of their combined market capitalization.
The web site “Investopaedia” relates the story of eToys in the USA, a classic illustration of how a bubble progresses through these stages. Here’s what they say.
“In May, 1999, with the internet revolution in full swing, eToys had a very successful initial public offering, where shares at $20 each escalated to $78 on their first trading day. The company was less than three years old at that point, and had grown sales to $30 million for the year ended March 31, 1999, from $0.7 million in the preceding year. Investors were very enthusiastic about the stock’s prospects, with the general thinking being that most toy buyers would buy toys online rather than at retail stores such as Toys “R” Us. This was the displacement phase of the bubble.
As the 8.3 million shares soared in its first day of trading on the Nasdaq, giving it a market value of $6.5 billion, investors were eager to buy the stock. While eToys had posted a net loss of $28.6 million on revenues of $30 million in its most recent fiscal year, investors were expecting for the financial situation of the firm to take a turn for the best. By the time markets closed on May 20, eToys sported a price/sales valuation that was largely exceeding that of rival Toys “R” Us, which had a stronger balance sheet. This marked the boom / euphoria stages of the bubble. Shortly afterwards, eToys fell 9% on concern that potential sales by company insiders could drag down the stock price, following the expiry of lockup agreements that placed restrictions on insider sales. Trading volume was exceptionally heavy that day, at nine-times the three-month daily average. The day’s drop brought the stock’s decline from its record high of $86 to 40%, identifying this as the profit-taking phase of the bubble.
By March, 2000, eToys had tumbled 81% from its October peak to about $16 on concerns about its spending. The company was spending an extraordinary $2.27 on advertising costs for every dollar of revenue generated. Although the investors were saying that this was the new economy of the future, such a business model simply is not sustainable.
In July 2000, eToys reported its fiscal first-quarter loss widened to $59.5 million from $20.8 million a year earlier, even as sales tripled over this period to $24.9 million. It added 219,000 new customers during the quarter, but the company was not able to show bottom-line profits. By this time, with the ongoing correction in technology shares, the stock was trading around $5.
Towards the end of the year, with losses continuing to mount, eToys would not meet its fiscal third-quarter sales forecast and had just four months of cash left. The stock, which had already been caught up in the panic selling of internet-related stocks since March and was trading around at slightly over $1, fell 73% to 28 cents by February, 2001. Since the company failed to retain a stable stock price of at least $1, it was delisted from the Nasdaq.
A month after it had reduced its workforce by 70%, eToys let go its remaining 300 workers and was forced to declare bankruptcy. By this time, eToys had lost $493 million over the previous three years, and had $274 million in outstanding debt.”
Speculative bubbles appear to be unavoidable in market economies, but clients should be on the lookout for the tell-tale signs of a bubble. That means not only recognising the disconnect of prices from fundamental valuations, but also looking out for the psychology of greed and wishful thinking that accompanies the typical bubble.please sign in to do this quiz