Perspective Crises, Manias and Irrational Exuberance Financial Bubbles Throughout History: A Cautionary Tale Executive Summary A bubble is a period when the price of an asset 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 leverage. Bubbles typically precede economic recessions, 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 stocks, bonds or real estate—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,” “economic bubble,” “market 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. Tulip Mania (1634–1637) Railway Mania (1840s) Tulip Mania 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 Ottoman Empire 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 1630s. 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 debts were enormous. BLACK TUESDAY South Sea bubble (1720) Wall Street crash of 1929 This was one of the first stock bubbles and the origin of the term Even today, nearly a century after it happened, the crash of 1929 “bubble”. It centered on the South Sea Company, to which the British remains the quintessential cautionary tale of a financial bubble. government had promised a monopoly on trade with Spain’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 speculation—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 unemployment, millions thrown into poverty, and thousands of bank failures in the Great Depression. 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 1990s) In response to a mid-1980s recession, 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 Webvan, 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 profit 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 deflation and stagnation (“stagflation”)— 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 short 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. “Black Monday,” 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 debt, 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 financial crisis 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 economist Hyman Minsky 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 the economist and investor John Maynard Keynes: 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 momentum 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 bankruptcy 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 u 21 of the 23 associated with financial crises, or 91%, followed a bubble.