What are the signs of a market bubble?

Everybody loves a good story. A good story, however, does not always make a good investment.

The big bubbles that have formed in markets over the past few centuries have proved this to be true.

Every time a bubble has formed, there has been a compelling story behind the rapidly rising prices. However, the story alone is never enough to make those high prices sustainable.

Lessons from history

A recent example is bitcoin. In the space of one year in 2017, the price went from around $900 to over $19 000. If anyone had been lucky enough to time this perfectly to buy at the start of the year and sell at the end of it, they would have gotten 19 times their money back.

By the end of 2018, however, the price had crashed back to $4 000.

The story of why bitcoin was becoming so valuable was, of course, exciting. This was a revolutionary new system of money. It was going to change the way that the world transacted.

Whether that is true or not is a separate debate. But even assuming that it is true, an astute investor would ask whether it necessarily justified prices rising so high so quickly.

Tulip mania

This is precisely the same thing that happened in what is believed to be the first modern market bubble: tulip mania in the Netherlands in 1636 and 1637. In this craze, Tulip bulbs became highly prized luxury items. The flowers were beautiful, the rich and famous wanted them, and so speculators assumed that no price would be too high to pay.

A tulip bulb, however, remains a tulip bulb. And, just like any other commodity, at some point, a sensible value is going to be established for one. That is when speculators may find themselves caught out.

A new bubble?

Recently, talk of bubbles has started to surface again. The speed of the market recovery since the coronavirus crash, has got many people wondering whether some stock prices aren’t getting too high too quickly, particularly since the global economy is still under a lot of pressure.

Most specifically, they worry that there a few stocks that are running way ahead of everything else. These are technology companies like Amazon, Netflix and Tesla.

Analysts are asking questions about these companies’ metrics, such as their price-to-earnings or price-to-book ratios. While these are undoubtedly important, the signs of a bubble are not strictly found in financial numbers. A bubble is, after all, the result of a particular psychology, and so if you really want to spot one, you should look at how people are behaving.

What to look for

The biggest clue is that you see people buying something because they are worried about missing out. They have heard about easy money being made, and so they want to make sure they get in on the party.

This was obviously the case with bitcoin. As the price went up in 2017, more people started talking about, and more people started buying it. The result was that more people started making money, and it so it became harder to stay on the sidelines.

When all your friends are telling you about how much the price of their bitcoin is going up week after week, it is difficult not to join them.

The second sign of a bubble is linked to this: that most of the people buying into a something that is rapidly rising in price won’t be able to explain rationally why it is going up. They will revert to saying things like: “it’s just obvious” or “you don’t get it”.

This relates back to the fact that bubbles always come with a good story. There is no question that cryptocurrencies are potentially revolutionary. But that, on its own, was not a reason for the price of bitcoin to double every few months.

In the same way, just because all the nobles in Netherlands wanted to have their portraits painted with tulips was not a good enough reason for the price of bulbs to go through the roof.

A new world

At times like this you also start to see the emergence of a whole wave of new experts. They generally have theories for why the world has fundamentally changed, and why whatever is happening in the market is justified by this new paradigm.

These people are often touted as “the next generation” of leadership — people who can see the new world for what it really is.

Scott Galloway, who was an internet entrepreneur at the time of the dotcom bubble, puts it like this:

“When times are bad, people look to grey hair for leadership. When times are good/frothy, people look for youth.”

Can you see the three signs now?

If you look around at the moment and you see these three signs, then that is undoubtedly reason to be cautious. The history of markets has taught us that people will keep making the same mistakes.

That people will get caught out by future bubbles is inevitable. But you don’t need to be one of them.

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