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Bubble And Bust Anatomy

Posted by: Brian Dennehy
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This is the second blog in our series marking the 10th anniversary of the 2008 Crash just ahead, the Great Financial Crisis. I explore the anatomy of a bubble and bust – and yes, this is very relevant today.
 
I ended last time by saying that:
 
“the potential problem is far greater than late-to-the-party investors underperforming the stock market as a whole. A multi-year downturn, secular bear market, can destroy a large part of your invested capital for a prolonged period and have very serious consequences in the wider economy.”
 
History suggests it is likely that a secular bear market is preceded by an investment bubble – so we need to explore what makes a bubble inflate and lay the foundation for an ugly bust. 
 
What lies at the heart of a mania was captured by Akerlof and Shiller in their book “Animal Spirits: How Human Psychology Drives the Economy”:
 
“Extremes are caused by the inter-action of confidence, greed and fear,
temptations, envy, resentment and illusions.”
 
And, in the case of a mania, a true bubble, they are held together by a good story, widely believed, which binds the crowd of investors more tightly together. 
 
Back in 1978 in the first edition of one of my favourite books, “Manias Panics and Crashes”, Charles Kindleberger set out the 5 stages of a full bubble/bust cycle (with a little help from the earlier work of Hyman Minsky).
 
He pointed out that on the whole markets work well, but occasionally “will be overwhelmed”. That is when they need help – I’ll return to the issue of “the help”, and for now these are the 5 stages.
 
1.       The Surprise
 
Not just any surprise, but some unexpected good news representing a fundamental change. The smart investors notice this rapidly and quickly start investing in the countries or sectors which will benefit from this change.
 
This surprise can be in many forms - the end of a war or an unexpected cut in taxes or interest rates. Or in more recent times it might be a change in financial markets, such as deregulation, perhaps combined with some financial innovation. At any time through history the positive surprise might have been some new technology.
 
In the 1990s new technology was key to the unfolding bubble. In the early “noughties” it was overly low interest rates and mortgage “innovation” which fuelled the bubble which burst 10 years ago.
 
(Kindleberger and Minsky called this stage “displacement” but I have changed his word to the more meaningful “surprise” stage)
 
2.       The Boom
 
That fundamental change becomes a good-news story – people love stories, and will invest based on good stories which are widely believed.
 
Lending begins to fuel the boom. People are willing to take on more debt, and banks are willing to lend more.
 
In 1920s America consumer loans came along to help people buy the new consumer goods, from refrigerators to cars. 
 
Confidence is obviously building, and the markets are heading up.
 
3.       The Euphoria
 
Everyone piles in. Many know little or nothing about investing – except that there is easy money to be made.
 
Boom morphs into euphoria – rational exuberance becomes irrational exuberance.
 
In the noughties “securitisation” of mortgages (a sensible idea) then morphed into a huge and corrupt web of deceit. (On which see the marvellous film “The Big Short”).
 
It is very clear at this stage that market valuations have lost touch with reality. But there is a belief that “this time is different” – and extreme valuations can be ignored.
 
For the 1990s we set this out in detail in our history of the technology bubble and bust (downloadable here).
 
Fraud is common but, at this stage in the bubbles development, it is largely undetected.
 
4.       The Crisis
 
Towards the top of the market the smart money, those who invested early, begin to sell, and this is balanced by late comer buyers. (Interestingly, before the 2008 Crash one of those early sellers was the boss of Lehman Brothers, Dick Fuld).
 
Then selling gathers momentum, probably triggered by some event - another “surprise” event, but this time a negative one. In 2008 the final straw was Lehman Brothers going bust.
 
The speculators and those late to the party hesitate – like Wile E. Coyote in the Roadrunner cartoon, they had kept running in mid-air, then momentarily hesitated and looked down – they suddenly realise it is a long way down! Very quickly euphoric buying is replaced by panic selling.
 
Instead of the usual “bubble bursting” analogy, Kindleberger thinks it is more like a young person on a bicycle. To stay upright the rider needs to maintain forward momentum – when momentum wains the bike begins to wobble at first, rather than immediately fall – then it crashes inelegantly to the floor.
 
5.       The Blame Game
 
As the Germans say, “torschlusspanik” – literally door-shut-panic. Prices plummet way below justifiable values, just as they did the opposite in The Euphoria stage. Liquidity then becomes a serious problem – not selling at any price, but rather whether you can sell at all, as with many corporate bonds in 2008.
 
Everyone is looking for someone to blame at this stage. The media are endlessly negative. Fraud and dodgy dealing is uncovered amongst those who were at the heart of the bubble, and amongst some very large players.
 
How bad it gets depends on the scale and type and quality of the debt, combined with the willingness of the authorities (central banks and governments) to act.
 
(Kindleberger and Minsky called this stage “revulsion”)
 
We have now got to the end of the boom/bubble/bust cycle. After the 2008 Great Financial Crisis the economic profession was given a hard time for not being able to predict it. Some economists then set off on a wild goose chase to try and discover the numbers (the equation or algorithm) which would predict such a crisis.
 
Numbers are not the story, they are just evidence of the story. They might illustrate that there is a bubble, but a bit of common sense and experience tells you that. The numbers themselves have no predictive ability. 
 
We aren’t observing a scientific phenomenon which can be expressed in an equation. This is a behavioral phenomenon.
 
Above all it is a cycle of confidence, from caution through euphoria to depression. And then it starts all over again from the ashes of the most recent bust.
 
Next time I will look at how this boom/bubble/bust structure fits events in 2008, and the relevance today – where the extremes of 2008 have been surpassed in key instances.

FURTHER READING
Topic: Market commentary


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