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Home , Black Monday (1894), Black Monday (1987), Economic bubble, Irrational exuberance, Railway Mania, South Sea Company

Perspective

Crises, Manias and Financial Bubbles Throughout History: A Cautionary Tale

Executive Summary A bubble is a period when the price of an irrationally exceeds the asset’s intrinsic value. Investors’ behavioral tendencies, when collectively taken to excess, lead to bubbles. The most common signs of bubbles are economic and financial, particularly extreme . Bubbles typically precede economic , even if the bubbles do not necessarily cause the recessions. Level-headed and disciplined planning can help investors to weather bubbles. In the financial world, a bubble is a period when the price of an asset—typically , bonds or —irrationally exceeds the asset’s intrinsic value. It is only a bubble, though, if it bursts and prices plummet, which may cause sellers to try frantically to get out. The terms “financial bubble,” “asset bubble,” “,” “ bubble” and “speculative bubble” are used interchangeably and often shortened to simply “bubble.” “Crisis” and “mania” are sometimes used as well.

Bubbles in History Learning about bubbles’ long history is perhaps the best way to understand them. There have been no fewer than 80 economic crises globally since the first century, including 25 in the twentieth century and 26 already in the twenty-first. Moreover, 27 of the 80—or one-third—took place in the U.S. either exclusively or as part of a wider phenomenon. Mania (1634–1637) () was one of the earliest recorded asset bubbles. In the Railway Mania was an economic and speculative bubble resulting sixteenth century, Westerners brought the tulip plant from the from the introduction of modern railroads to Britain. Like the Internet to Europe, where its then-rarity and exotic beauty bubble 150 years later, it was marked by investors’ insatiable attracted speculators from a wide cross-section of Dutch society in appetite for a disruptive technology. Railroad stocks soared to the . The price of a tulip bulb reportedly rocketed twenty-fold dizzying heights and massive overbuilding took place: At one between November 1636 and February 1637, only to plunge 99% in point, the money put into railway construction was more than three months. Fortunes were lost and the Dutch economy sank into a double British military spending. When the bubble popped, many mild depression. railroad companies went under, shareholders were devastated and outstanding were enormous.

BLACK TUESDAY

South Sea bubble (1720) Wall Street crash of 1929 This was one of the first bubbles and the origin of the term Even today, nearly a century after it happened, the crash of 1929 “bubble”. It centered on the , to which the British remains the quintessential cautionary tale of a financial bubble. government had promised a monopoly on trade with ’s South Many of the fundamental bubble characteristics that we describe American colonies in exchange for the assumption of Britain’s later—excessive use of leverage to buy stocks, herd-like behavior, massive war debts. South Sea shares soared more than 800% in overconfidence and the mass popularity of —were 1720 on false rumors of the company’s huge success. Thousands of present and unstoppable. overextended investors across British society were ruined when the Even though the “official” crash occurred on October 29, 1929 (the share price collapsed, causing a severe economic crisis. infamous “Black Tuesday”), prices continued to drop and finally bottomed three years later. The repercussions were widespread and devastating, with suicides, sky-high , millions thrown into poverty, and thousands of failures in the .

Page 1 | FINANCIAL BUBBLES THROUGHOUT HISTORY Where does the term ‘bubble’ come from? Used in a financial context, the term “bubble” dates back to the 1720 British South Sea bubble, in which executives of England’s South Sea Company greatly exaggerated the company’s business prospects to drive up the price of its shares. “Bubble” referred to the inflated shares of South Sea and the other companies involved: Their prices expanded based on nothing but air and were vulnerable to a sudden burst.

Japanese economic bubble (1980s) Internet/dot.com bubble (late ) In response to a mid-1980s , the Japanese government The internet bubble—also known as the dot.com bubble or the tech undertook aggressive fiscal and monetary stimulus to turn the nation’s bubble—was a classic case of mass market hysteria. The excitement of economy around. The plan worked too well: The subsequent economic the then-nascent internet lured investors into the stocks of web-related boom resulted in Japanese stock prices and urban land values names like , Pets.com, eToys.com and many others that had tripling between 1985 and the bubble’s peak in 1989. Japan’s economy not even turned a yet. Valuations went through the roof amid deteriorated after that, as stocks and real estate slid and led the country declarations of a new status quo in which earnings did not matter. The into an agonizing period of and stagnation (“”)— tech-dominated NASDAQ Composite Index spiked to a new high in known as the lost decades—that lasted more than 20 years. March 2000 and then dropped like a rock before bottoming in October 2002. As if on cue, a recession followed the peak.

BLACK MONDAY

Stock market crash of 1987 U.S. housing bubble (2007–2009) The bubble in U.S. stocks that inflated in 1986 burst wide open on The housing bubble was painful proof that investors have October 19, 1987, when the Dow Jones Industrial Average fell 22.6%—still memories. Even as the economy and financial markets emerged the biggest single-day percentage loss in U.S. history. “,” from the wreckage of the internet bubble, a new home-buying mania as it is known, was the culmination of euphoric speculation fueled by took shape. In retrospect, warning signs abounded: unsustainable hostile takeovers, insider trading, a flood of initial public offerings (IPOs) consumer , rampant mortgage fraud, mounting defaults, willful and newly popular leveraged buyouts funded by junk bonds. ignorance of credit deterioration in mortgage-related securities— But the nail in the coffin that day was portfolio insurance, an automated yet most investors looked the other way. The resulting global hedging strategy in which big institutions sold stock-index futures to was the worst economic contraction since the Great soften the blow of falling prices. Portfolio insurance programs kicked in Depression, and the world continues to feel its effects today. as the sell-off raged—resulting in yet more selling and exacerbating the decline. Unlike most bubbles, Black Monday did not feed a recession, as stocks recovered within weeks and resumed their upward climb. FINANCIAL BUBBLES THROUGHOUT HISTORY | Page 2 A Consistent Pattern Bubbles tend to follow a pattern consisting of several stages. The identified five stages as part of his financial instability hypothesis (see chart below). While Minsky focused on the workings of credit cycles, his stages are equally applicable to bubbles.

Stage Stage 1 Displacement 4 Profit taking/Crisis This is when investors get excited about a new development they The warning signs of froth are clear to investors willing to notice them, expect will dramatically change the world. In the late 1990s and early and they sell their positions accordingly. It’s worth noting that this 2000s, for instance, the advent of the internet popularized the phrases is much easier said than done, however, as reflected in a quotation “new paradigm” and “new economy” as shorthand for how information- attributed to and investor : based technology would transform both daily life and economic reality. Markets can remain irrational a lot longer Stage 2 Boom than you and I can remain solvent. ­ — John Maynard Keynes Asset prices rise slowly and take on as investors increasingly flock to the market. Speculation drives prices higher, which attracts more investors who do not want to miss out on the excitement—which attracts even more investors. Stage 5 Panic Stage The green light of investor sentiment turns bright red, and prices Euphoria 3 plummet as quickly as they had soared in stages 2 and 3. Sellers run for the exits and want to liquidate at any price. A great example Prices skyrocket and pull valuations with them, leading the market of panic was the global sell-off in October 2008 on the heels of the into dangerously vulnerable territory. Investors seize on new Lehman Brothers and the near-collapse of giant financial measures of valuation to justify soaring prices. In the dot.com bubble, intermediaries AIG, Fannie Mae and Freddie Mac. “clicks” and “eyeballs” exemplified such measures as analysts sought new ways to value companies that, in many cases, were years away from generating profits.

Stage 1 Displacement Stage 5 Panic Minsky’s 5 Stages Stage 2 Boom Crisis Stage 4 Euphoria Stage 3

As adapted by economic historian Charles Kindleberger. Source: Kindleberger, SG Cross Asset Research.

Page 3 | FINANCIAL BUBBLES THROUGHOUT HISTORY The Recession Connection There is another important pattern among bubbles: frequently, they Recessions after World War II are followed by economic recessions, even if the bubbles do not necessarily cause the recessions. Financial crisis recessions "Normal" recessions A recent study of bubbles in 17 nations spanning North America, preceded by bubbles preceded by bubbles Europe and Japan revealed that since World War II there have been 88 recessions, of which 62 (70%) were preceded by a bubble in equities, housing or both. The study broke down the 88 recessions further, into those associated with financial crises and those % % considered “normal” recessions: 91 63 uu 21 of the 23 associated with financial crises, or 91%, followed a bubble. uu 41 of the 65 normal recessions, or 63%, followed a bubble. Preceded by bubble ot preceded by bubble

Source: Òscar Jordà, Moritz Schularick and Alan M. Taylor, “Leveraged Bubbles,” National Bureau of Economic Research (NBER) Working Paper No. 21486, August 2015. Note: Recessions are the peaks of business cycles identified using the Bry and Boschan (1971) algorithm. A recession is labeled financial if there is a financial crisis within a two-year window of the peak. Otherwise it is labeled normal. Bubble episodes are associated with recessions by considering the expansion over which the bubble takes place and using the subsequent peak.

We Are Only Human—Which Can Be a Problem Each bubble has its own specific circumstances and must be seen in The holds that we can safely buy a soaring the context of its time. Yet the ultimate cause of any bubble is timeless: asset because there will always be someone more foolish than us human behavioral tendencies taken to excess. From the Dutch Tulip to whom we can sell it at a higher price. In bubbles, however, there’s mania to the global financial crisis, it has been people’s emotionally always a greatest fool out there who ends up paying the top price and driven buying and selling decisions—along with their fear of missing cannot find a buyer who will go higher. out—that have inflated bubbles and eventually burst them. Confirmation bias holds that we look for new information that What are the tendencies that resulted in such decisions? , confirms what we think and avoid information that contradicts it. The psychologists and sociologists have identified a number of them: result is a one-sided view that causes investors to make poor decisions, whether in choosing investments or timing a purchase or sale. Extrapolation is the projection of past trends into the future. If a stock has risen at a particular annualized rate in the past few years, Overconfidence in our own intuition can be a powerful driver of we might assume that it will continue to do so going forward. If taken market activity. Too often, we make investment decisions by trusting to extremes—as happens in bubbles—this could cause overbidding for our gut rather than weighing the hard evidence in front of us—in other stocks that have become very risky. It was not so long ago that millions words, we choose to ignore reality. of people kept buying homes based on the false premise that “home prices will always rise.” Wishful thinking is a bias in favor of things to which we feel an emotional attachment. It could be our favorite sports team, a lucky Herding is the tendency to do what the crowd is doing because if so number or that crazy stock we have been riding up into the stratosphere. many people are doing it, it must be right—even when we know it does not make sense. We are afraid of missing out on what “everybody” is “This time it is different” is an of magnitude up from wishful thinking. We all want to believe that the past will not repeat doing, so we just follow them down the rabbit hole. Tech stocks at the turn of the millennium or the pre-Black Monday IPO craze come to mind itself because we are in a new environment in which the old status quo no longer applies. So we keep buying inflated stocks, gorging on high- in this context. yield bonds or mortgaging our first home to buy another one—until the bubble pops and we pay the inevitable price for our willful blindness.

FINANCIAL BUBBLES THROUGHOUT HISTORY | Page 4 The Cycle of Investor Emotions It is natural to think we can avoid the tendencies that drive bubbles. But financial crisis that, “A simple rule dictates my buying: Be fearful when 1 this thought just confirms that the tendencies exist—most prominently others are greedy, and be greedy when others are fearful.” overconfidence, wishful thinking and “this time it’s different.”

The chart below illustrates the emotions we typically feel as our specific holdings or the broader market go through a bubble’s boom- A simple rule dictates my buying: Be fearful and-bust cycle. Note that we feel euphoria (the same word used by when others are greedy, and be greedy when Minsky to name his third stage of financial instability) at the top of the others are fearful. cycle, where it is actually riskiest to participate, and despondency at — the bottom, where the biggest opportunities sit for the taking.

If we acted at the extreme points of the cycle based on our emotions, we would be throwing our money away. Better to heed the advice of By keeping Buffett’s words—and simple common sense—firmly in mind, Warren Buffett, who built his fortune by listening to his head instead we can sidestep the temptations of the bubble mentality. Why depend of his heart. Buffett famously wrote during the depths of the global on the greater fool when we don’t have to be fools in the first place?

Point of maximum financial risk “Temporary setback. “Wow, I made a I’m a long-term investor.” great investment.” Euphoria Anxiety

Thrill Denial

Fear Excitement Point of maximum Depression financial opportunity

Panic Optimism Relief Capitulation Optimism Hope Depression Despondency “Maybe the markets just aren’t for me.”

Hypothetical example shown for illustrative purposes only.

How to Spot a Bubble Despite how extreme bubbles can be, we cannot definitely identify one Unusually high use of credit to purchase until it is over. What is more, a sustained period of overvaluation is not necessarily a bubble, as such periods usually end with corrections that Buying stocks primarily on , making minimal down payments bring prices down without flattening them. on homes and acquiring companies via highly leveraged buyouts are good examples. What are the signs indicating that a bubble might be happening? Following are the those most frequently mentioned by economic Higher-risk lending and borrowing historians and seasoned market watchers. Note that most of the signs are economic and financial, underscoring the critical role that non- Just think of the housing bubble, when mortgages with onerous terms market factors play in bubbles: were aggressively sold to borrowers with limited ability to pay the mortgages back.

1 “Buy American. I Am.” , October 16, 2008.

Page 5 | FINANCIAL BUBBLES THROUGHOUT HISTORY Low interest rates imbalances

In and of themselves, low interest rates are a sound way to encourage When nations save more than they invest, they eventually want to put investment, whether in securities, capital equipment, research those savings where they think they will earn a good return. Sometimes and development or corporate acquisitions. But low rates also that increases the of capital flows among countries—as can be dangerous if they stimulate speculative activity, excessive happened in the housing bubble, when flows from savings-heavy Asian indebtedness and greater overall tolerance of risk. nations poured into U.S. and helped to keep prices rising.

Financial innovation Heavy marketing or media coverage

Big market participants are always looking for a financial edge. Two If it seems like everyone is excited about a particular asset, chances such innovations—futures-based portfolio insurance and credit default are good that its upside either has peaked or is declining. swaps—played major roles in the crash of 1987 and the U.S. housing bubble, respectively. Amateur hour

The market may indeed be veering off its tracks when all kinds of people with little knowledge of investing are talking like experts, with off-the-charts conviction about the inevitability of higher prices.

How Can Investors Prepare? It is one thing to know about bubbles and understand what drives them and how they work, but quite another to manage a portfolio through them. There are a number of steps investors can take that are straightforward, time-tested and may be savvy in any market environment.

The first move happens well before any bubble signs appear. Investors should work with their financial advisor to develop a long-term investment plan that can endure through good times and bad—and stick to it. In addition, investors should aim to:

uu Avoid emotional attachment to holdings and try to keep uu Stay away from excessive leverage, whether in the form of feelings out of the decision-making process. buying stocks on margin or external borrowing to fund asset uu Maintain a well-diversified portfolio, which is the best purchases. Leverage only worsens the potential losses from defense against almost any market volatility or downturn. a bubble. u uu Rebalance portfolios on a consistent schedule—annually, u Avoid investments that are not fully understood. Many semiannually or quarterly is widely recommended—to trim investors—both individuals and institutions—racked up big exposure to bubbly assets and add to others that may show losses in the housing and internet bubbles because they greater promise. bought complicated mortgage-related securities or stocks of companies with esoteric technologies.

If history teaches us anything, it is that bubbles will always recur. But by remembering that “This time, it is almost definitely not different,” investors can relearn this important lesson and focus on managing risk and protecting assets.

Contact your financial advisor to learn more about INVESTMENT ESSENTIALS or visit amgfunds.com/essentials for more information.

FINANCIAL BUBBLES THROUGHOUT HISTORY | Page 6 About AMG Funds

The largest network of institutional All investments are subject to risk including possible loss of principal. Diversification does not guarantee a profit or protect against a loss in declining quality boutique investment solutions markets. through a single point of access The foregoing discussion is general in nature, is intended for informational purposes only and is not intended to provide specific advice or recommendations for any individual or organization. Because the facts and circumstances surrounding each situation differ, you should consult your attorney, advisor or other professional advisor for advice on your particular situation. Unrivaled access to insights of over Definitions: 30 independent and autonomous Credit default swap—A swap is a contract through which two parties investment managers exchange financial instruments (A derivative is a with a price that is dependent upon or derived from one or more underlying assets.) A credit default swap is a particular type of swap designed to transfer the credit exposure of fixed income products between two or more parties. Deflation—The general decline in prices for goods and services occurring when the rate falls below 0%. More than 100 actively managed (IPO)—The very first sale of stock issued by a company to the public. Prior to an IPO the company is considered private, with a relatively products covering the risk spectrum for small number of shareholders. Until a company’s stock is offered for sale to the investors searching beyond the index public, the public is unable to invest in it. —The acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company. Portfolio insurance—A hedging technique frequently used by institutional investors when market direction is uncertain or volatile. Stagflation—A condition of slow and relatively high unemployment, or economic stagnation, accompanied by rising prices, or inflation. AMG Distributors, Inc., is a member of FINRA/SIPC.

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