In 17th century Holland, the first speculative asset bubble in history occurred—called Tulip Mania1. Tulip bulbs, of all things, got bid up in price to the point where a single bulb came to represent many times the annual income of a middle-class household. Then, it collapsed. The bubble burst. People came to realize they were just flowers.
About a century later another bubble formed—the South Sea Bubble. This one involved the South Sea Company, a British joint-stock company. None other than Sir Isaac Newton, the astronomer, was swept up in it. Newton invested his money in shares of the company and later sold them at a 100 percent profit. But, as the price of the stock continued to shoot upwards, Newton jumped back in—and lost more than $3 million2 as the share price collapsed. Following the experience, Newton said: “I can calculate the motion of heavenly bodies, but not the madness of people.”
Many asset bubbles have occurred throughout history.
The biggest and perhaps most historic was the 1920s stock market bubble. After peaking on September 3, 1929, the stock market went on to lose 89 percent of its value, bottoming almost three years later in 1932.
Then there was the 1990s stock market bubble, fueled by the internet. The stock market would peak in March of 2000, bottoming just over two years later—down 50 percent from its high.
Following the 2000 stock market bubble a housing bubble formed in the U.S., popping in 2008 and leading to the Financial Crisis in 2008-09.
Bubbles have been present throughout history in various asset classes.
What causes bubbles?
Bubbles are caused by too much money chasing one theme.
They each start with a nugget of truth but get carried away.
The 1920s stock bubble was fueled by economic progress, which was real, but was carried to excess in the public’s enthusiasm for how quickly it would come into fruition.
Same with the 1990s stock bubble. It was driven by the internet, which was going to change the world, and did, but the expectations of how quickly that would happen were taken to excess.
Same goes for the U.S. housing crisis. Real estate historically has been a good investment. But not always. It depends on the price you pay for it.
Everything can be taken to excess.
Even the soundest investment.
The best asset makes a terrible investment if bought at too high of a price.
Stages of a Bubble
The stages of a bubble typically go like this:
Each starts with an exogenous shock, like the birth of the internet, which captivates the public’s attention and attracts investment.
Easy money (low interest rates) fuels the bubble, as it did with stocks in the 1920s and 1990s, and housing prices in the 2000s.
The public places their faith in the central banker to keep the party going. They come to believe central banks won’t let the bubble pop, which turns out to be false.
Finally, con men come out of the woodwork. Each bubble typically has a Charles Ponzi (originator of the Ponzi scheme) or Bernie Madoff type character, who is discovered only after the bubble has burst.
Price
Each bubble is fueled by a disregard for price.
Ben Graham’s margin of safety concept—buying something for less than it’s worth in case something goes wrong—goes out the window. People begin paying up for assets, eliminating the margin of safety, and introducing risk.
Investment legend Howard Marks put it like this:
The problem is that in bubbles, “attractive” morphs into “attractive at any price.” People often say, “it’s fully priced, but I think it’ll become more so.” Buying or holding on that basis is extremely chancy, but that’s what makes bubbles.”
People begin to believe the bullshit.
Air In, Air Out
Bubbles typically build slowly, then deflate quickly.
The 90s internet bubble took the better part of a decade to develop. Then, in about two years, 50 percent of the air went out of the bubble.
The tricky thing is knowing what will pop a bubble.
Maggie Maher, in her book Bull!, likened an asset bubble to an avalanche:
Once enough snow has accumulated, it’s hard to know what will trigger the avalanche. It can be almost anything—a tree branch, a deer, a skier—what really causes it is that you have an unstable snow buildup.
Warren Buffett said this:
A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street—a community in which quality control is not prized—will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.
The air has to come out of every bubble. It’s just a matter of when.
Retrospect
An asset bubble is only recognized as a bubble in retrospect.
An old saying in investing is that when your barber or taxi driver starts giving stock tips, look out. A bubble has likely formed and is soon going to pop.
I think similar wisdom can apply today to any asset. When the general public starts incredulously talking about the appreciation of a given asset or asset class’s price, you probably want to be careful.
Howard Marks put it like this:
Time and again, the postmortems of financial debacles include two classic phrases: “It was too good to be true” and “What were they thinking?”
It’s only when people stop believing, that prices fall. Each bubble develops based on beliefs and for the bubble to continue, people have to continue to believe. Once they stop, harsh reality sets in.
Bottom Line
Asset bubbles have been present throughout history.
They are driven by emotion. Humans get carried away by the potential of a given asset.
When this happens, you want to beware.
All bubbles blown big enough eventually pop and leave a sticky residue on all involved.
The Intelligent Investor, Zweig