“I can calculate the movement of stars, but not the madness of men.”

Sir Issac Newton (after losing money in the South Sea Bubble, 1720)

Financial bubbles and crashes have been a frequent occurrence throughout the recorded world history. Almost all have led to bankruptcies, job losses, and financial distress.  If meltdown of bubbles is so painful, why can’t we stop them? Won’t it be better if prices remain etched to the financial worth of underlying securities/ assets, and owners earned the natural yields of those assets?

We scanned over 10 episodes of bubbles and crashes of last 400 years – including Tulip Mania of 1636, the Great Depression of 1929, the Dot Com bubble of 1999, the Sub-prime crisis of 2008 etc – to try and understand the causes of bubbles and crashes. The objective was to pull out/ revise lessons that today’s enthusiastic investors can learn from and avoid similar mental and financial toil.

Initial Rational Source: In almost all the bubbles of last 400 years, one or more of the following were the initial source(s) of economic exuberance:

Most of the above measures were taken in pursuit of progress and economic well-being. And most of these measures were justified reasons for imagining a brighter future. They did improve lives and general wealth.

Wealth Effect: Anticipation of higher demand and growth due to above initial events leads to rise in asset prices. Banks get comfortable lending funds against security of these inflating assets. Raising money through equities become cheaper. Easy availability of both debt and equity capital at low cost of capital encourages capital investments and job creation. This raises incomes and thereafter consumption. The wealth effect thus feeds itself. 

Greater Fool Theory: What turns initial optimism into euphoria and bubble is the over estimation of brighter future, animal spirits and emotional outburst of greed, envy and fear of missing out (FOMO). Wealth effect leads to general sense of prosperity. It triggers envy and FOMO among sideliners. Prices start to detach from underlying reality. People buy in the hope that others may buy from them at even higher price – the Greater Fool Theory.

Timing the top: Sadly, sooner or later the supply of greater fools run out. Some external event happens that makes prices to first stop rising and then start falling. Those not able to service debt or expenses are forced to liquidate falling assets. Gradually greed turns to fear and wisdom of crowds turns into stampede of folly. If we try to pick clues about being able to time the peaks, we will return disappointed. For, there is no upper range of time in months when a bubble pops. However, sooner or later, it does pop. Following have been one or more common crash triggers/ escalators of the past:

 Saviour: Primary protection against emotional follies of envy, greed, fear of missing out and overconfidence in an overheated market is to remember what Benjamin Graham and Warren Buffett said about bubbles and human nature –

“The investor’s chief problem, and even his worst enemy, is likely to be himself”

“Be fearful when others are greedy”

Low interest rates have been often cited as a justification for higher equity valuations. When fixed income instruments are yielding 0%-2% in the developed world, investors flock to riskier assets in search of higher returns and equities benefit from this lack of investible opportunities.

However, a corollary to this is lower future equity returns. If investors believe that lower interest rates offer arbitrage benefit to equities and bid up equity prices, this act should reduce the arbitrage and make future returns of all asset classes converge. In other words, if interest rates of 1% around the world pushes money towards equities, future returns from equities will not be different from 1%. Many investors do not take this into account.

Secondly, there is an implicit assumption that interest rate will remain so low forever. If that’s not the case and rates do rise, they will hit a long tenured asset harder. A 10 year bond falls more in % terms than a 1 year bond for a same rise in interest rates. And equities are perpetual assets. If interest rates do rise, equities are going to fall substantially more.

While everyone’s happy that lower interest rates and abundant capital supports rising equity prices, here’s an outcome that many investing carelessly today may not like: low equity returns if interest rates remain low; and negative equity returns if interest rate increase even marginally. When prices are bid up aggressively – heads you lose, tails you lose too!

The one safeguard against this is to buy equities assuming that interest rates are already high and leave some margin of safety.