How to Spot a Market Bubble

| October 15, 2017

Holland in the 1600s was an interesting time. This period is referred to as the Dutch Golden Age, and the people who were experiencing it were developing a taste for luxury items that their intrepid world explorers would bring back from the far corners of the globe. One of those items was the tulip flower, which was first sent to Europe by an ambassador to the Ottoman Empire. The tulip quickly caught the fancy of the people, as it was different than any other flower they had seen, possessing an intense petal color and inviting shape. Soon, it became a status symbol to have one in your possession, and the bulbs became much-coveted items. As jockeying for the imported tulip bulbs continued, the price of the luxury item increased. It was said that at the peak of tulip mania, the price of a single bulb was more than 10 times the annual income of a skilled craftsman.

Then, one day, the people woke up. For no apparent reason other than a great awakening to the foolishness of such speculation, the prices for tulips and their future import contracts suddenly collapsed, ruining many who had significant funds tied up in the market. Thus, what is considered the world’s first speculative market bubble came to an end. Today, tulip mania is still remembered and cited any time a market seems to become overheated. Just in September of this year, JPMorgan Chase CEO Jamie Dimon likened Bitcoin speculation to Holland’s former tulip frenzy. The remembrance tends to rear its head anytime the price of an object exceeds what many believe are its intrinsic values.

Market bubbles happen in stocks, real estate, cryptocurrencies, and even tangible objects like baseball cards, guitars, and comic books. They’re fueled by desire, pride, ambition, and often a somewhat delusional belief that prices will continuously go up, oblivious to history and common sense. A book written about the Dutch tulip craze tells it all through its title: Extraordinarily Popular Delusions and the Madness of Crowds. It’s been said you know there’s a bubble when your grandmother or a cab driver starts talking about the financial instrument and its rising price, indicating the frenzy for a particular item has become mainstream.

The problem with bubbles is that they are hard to spot. Circumstances change, markets overheat, black swan events create unexpected problems, and even things like the weather can change attitudes. It is usually only in hindsight that we then see whether something was a bubble.

RESEARCH SEEKS TO IDENTIFY

Harvard research came up with some factors that may help investors identify a market bubble and its ensuing crash. The academics examined crashes in many industries, including the famous dot-com bubble of 2000, to see if there were common factors.

They discovered escalating price increases don’t necessarily signal a bubble, as many believe.  Instead they say there are five keys to a bubble: speculation, volatility, stock issuance, accelerated price increases, and a disproportionate rise in prices among newer firms.

Harvard researchers found that bubble industries were generally dominated by younger firms. They were marked by significant price volatility in individual stocks, with those young firms issuing a lot of stock or going public in very short periods of time. That kind of frenzy tended to accelerate stock prices far beyond norms.

The 1929 stock market crash and dot-com bubble are prime examples of situations that fit the bubble profile. In 1929, the country was becoming electrified, and new utility stocks were all the rage. In the 1990s, the internet was taking flight, and this new form of communication fueled massive speculation in the achievements of companies dominated by young technicians.

WHAT MAY BE A BUBBLE

Applying those lessons to current circumstances is tricky. Real estate was said to be in a bubble in the mid-2000s. But it turned out that speculation in exotic financial instruments and risky behavior by big banks were to blame.

Similarly, the internet bubble of 2000 wasn’t caused by technology underpinning companies. Instead, some of the concepts, such as selling toys, were not refined enough or were run by companies that were not entrenched in their industries. Once the big boys caught up and having a website became mandatory, supply chain issues that constrained previous iterations of services vanished. Today, there are several dominant companies and a network of camp followers that are thriving.

Finally, we arrive at one of the biggest markets of today, and some already say it’s in a bubble.
Prices for Bitcoin and other digital currencies have rallied since the beginning of the year. The rises have been so spectacular that members of the old guard, like J.P. Morgan’s Dimon calls it a fraud. Of course, all of the classic signs of a financial bubble are there – speculation, exuberance, young companies rapidly expanding, the use of exotic financial instruments, and a general sense that the cryptocurrency market is unstoppable. Is it a bubble? Although there is extreme volatility in the market, it has generally managed to build an infrastructure that resembles the more established internet businesses, perhaps showing that some lessons have been learned.

The sector may still be in a bubble, and investors are always advised not to place their last dollar into any particular investment. But until it finally collapses, having a tulip – er, bitcoin – is a mark of financial sophistication. At least to some observers.