Is there really such a thing as a market bubble? I feel almost heretical answering this question. I and most readers have lived through two decades that were dominated by two vast investment bubbles and the attempt to deal with their consequences when they burst.
Getting into definitions is beside the point. As US Supreme Court Justice Potter Stewart once said to define pornography: “I know it when I see it.” And there is no point in arguing that the dotcom bubble that came to a head in 2000, or the credit bubble that burst seven years later, were not bubbles. I know a bubble when I see one, and they were bubbles. For those of my generation, spotting bubbles before they get too big, and thwarting them, seems to be vital for regulators and investors alike.
The history of financial bubbles is long and fascinating. The greatest bubbles in history have many common characteristics. After the disasters of recent years, investors have been spurred to rake over that history. Events from the 16th century Dutch tulip bubble through to the Panic of 1907 have been raked over for their significance.
But in a great new compendium on financial history, several writers make the same points. The number of bubbles in history is very small. That makes it hard to draw any valid inferences from them. Further, definition is a real problem, and not just one for linguistic nitpickers. History’s acknowledged bubbles all have one critical factor in common; they burst. But that gives us a one-sided view. We need to look at those bubbles that did not burst and the crises that did not happen.
Once looked at this way, the dilemmas of dealing with bubbles grow more intractable. It is harder for investors to take evasive action. The critical policy question of whether central banks and regulators should prevent the formation of bubbles also grows harder to answer.
Yale’s Will Goetzmann complains that bubbles are booms that go bad — “but not all booms are bad”. Using data for national indices from a range of countries in the 20th century, he found that after a boom, crashes that gave back all of their previous gain were more rare than instances where prices doubled again.
He defined a bubble as an extreme acceleration in share prices. In one version, he required them to double in a year — which excluded the dotcom bubble and the Great Crash of 1929. To keep them in, he also tried a softer version where stocks doubled in three years.
The background history to these booms confirmed what historians of bubbles had already shown: that they always have at least some backing from the fundamentals. Bubbles may end up being irrationally expensive, but they are not stupid. They arrive when an exciting new development — canals, railways, the internet — creates confusion over the future value they will create. As he puts it, “there was at least some method to the madness of investors”.
He found 72 cases of a market doubling in a year. In the following year, six doubled again, and three halved, giving back all their gains: Argentina in 1977, Austria in 1924 and Poland in 1994.
For doubling in three years, he found 460 examples. In the following five years, 10.4 per cent of them halved. The possibility of halving in any three-year period, regardless of what had come before, was lower than this but not dramatically so: 6 per cent.
On this basis, arguments made by many (including me) that central banks should concentrate more on pricking bubbles before they get too big begin to look threadbare. At a minimum, he has provided historians with a fascinating new pool of bubbles that we should now try to explore. They range from the easy to explain — anyone who knows anything about 20th century history can work out why the German stock market dropped 84 per cent in the five years after it doubled in 1940 — to the far more baffling. If any reader knows what went wrong for New Zealand stocks after 1986, or Norwegian stocks after 1973, it would be most interesting to hear.
As for the booms that went on, try postwar Germany, Peru in the late 1980s, Russia after 1999 — it almost trebled in the following five years, in the early stage of Vladimir Putin’s pre-eminence — or even the UK in 1975. UK stocks doubled that year, and trebled again by the end of the decade.
How should investors deal with this? Getting out altogether when a market grows overheated is dangerous. You give up on the extra premium that the market normally gives you for taking the extra risk of buying stocks. And attempting to time the market based on valuation does not work. As Mr Goetzmann’s essays show, markets can easily grow even more overheated.
I hate to repeat what I have said many times before, but rebalancing has much to be said for it. Steadily take profits each year as markets rise, and over time you will gain. In the long run, buying something that is obviously expensive seldom works out. Beyond that, remember that some booms do not go bust.
‘Financial Market History: Reflections on the Past for Investors Today’ by David Chambers and Elroy Dimson, CFA Institute Research Foundation; Amazon UK £31.94, Amazon US $38.95