A 'First-Principles' Look at Market Bubbles

Most of us have lived through a few major market bubbles. Some might have experienced the gold and silver bubble in the late 1970s or the Japanese real estate bubble in the late 1980s. Many will remember the Dot-com bubble in the late 1990s and the US housing bubble of the mid 2000s. All of these market bubbles ended badly.

There are several excellent historical accounts of bubbles (notable examples include Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds, and Charles Kindleberger’s Manias, Panics & Crashes: A History of Financial Crises). History is filled with bubbles we can analyze, ranging from tulip bulbs to Internet stocks, and from this wide array of examples we can spot patterns and draw conclusions to try and help us prepare for the next bubble.

One could argue that we are currently living amid several asset bubbles, and if so, we should probably be concerned about when and how they might end. The characteristic feature of bubbles is a pattern of an exponentially rising price followed by an abrupt collapse. Market bubbles are easy to identify after the fact but trying to identify them ex-ante is significantly more challenging.

What is a “bubble”?

So, we use the following rules:

1. Bubbles only occur in goods that can be held for resale. Think homes, cryptocurrency, not food or Netflix subscriptions.
2. The more intangible an asset’s value, the more susceptible it is to asset bubbles. It’s important to note that intangible assets were 90% of the value of S&P 500 companies in 20201 (the highest it’s ever been).
3. In a bubble, there may be no stable price equilibrium according to a normal supply/ demand pricing model. Let’s consider Bitcoin as an illustrative example. A year ago, one Bitcoin was $10,000 and it’s now around $50,000. The steep ascent in cryptocurrency prices has been a driver of demand, as market participants optimistically anticipate further price appreciation, and may even suffer from “FOMO” (fear of missing out). Imagine, however that at some point in the near future, one Bitcoin is still selling for around C$50,000 but the price had peaked at C$100,000 and was in the process of falling precipitously Would demand then be the same as demand today? It’s doubtful, as the optimistic sentiment would have been replaced by pessimism from market participants projecting further price declines, so demand would likely be much lower despite the price being the same. If a market can have completely different levels of demand at the same price, then the demand is not solely a function of price, and there is not a defined demand curve.
4. In a bubble, new supply of substitute goods will be brought to market. Eventually more homes will be built, or new cryptocurrencies brought to market.
5. In the long run, all bubbles will burst. This is an adaptation of Stein’s Rule: "Things that can’t go on forever, don’t." As long as the laws of supply and demand hold, bubbles cannot persist indefinitely.

How do you identify a bubble?

Economist Richard Thaler (the recipient of the 2017 Nobel Memorial Prize) is arguably the world’s pre-eminent authority in behavioral economics. Market bubbles are clearly a behavioural phenomenon, but according to Thaler “It’s impossible to know for sure whether something’s a bubble.” He's not alone. Economist Eugene Fama (co-recipient of the 2013 Nobel Memorial Prize) said of bubbles “I want a systematic way of identifying them. All the tests people have done trying to do that don’t work. Statistically, people have not come up with ways of identifying bubbles.”

If Nobel Prize winning economists like Thaler and Fama tell us that they cannot identify bubbles ex-ante, what hope do we have? It may indeed be academically impossible to prove that a market is in a bubble if a standard of certainty is required, but in practice, almost nothing is certain. In the real world, we have no choice but to live with uncertainty. The best we can do is make a reasonable estimate as to the likelihood of whether a particular market might be a bubble.

The most reliable signs that bubble conditions may exist in a market are that sentiment takes precedence over fundamentals. Or in economic terms, hoarding and dishoarding in anticipation of price movements become bigger drivers of demand and supply than ordinary consumption and production.

The most tell-tale indicator of a bubble may be hearing people express sentiments like “I can’t explain why the price is rising, but I should hurry up and buy before the price gets even higher.” (This is mirrored in market panics by the sentiment “I can’t explain know why the price is falling, but I should hurry up and sell before the price gets even lower.”)

How do you safely navigate through bubbles?

Even if we cannot know with certainty whether a bubble exists, now that we have some tools to help spot whether there is the risk of a bubble, we should give some thought to the appropriate precautions.

If the asset meets the criteria for susceptibility to bubbles (i.e. something that is held for resale, intangible value, etc.), and people are eagerly buying at seemingly irrationally high prices in anticipation of even higher prices in the future, it’s probably safe to assume the market may be in a bubble. If there is a wide gap between the market price and any valuation that can be reasonably justified by fundamentals, let the fundamentals be your guide.

Try not to succumb to “fear of missing out” and resist the temptation to speculate on where prices might go. Assume that the price in the future will be no higher than today’s fundamentals would support (which might be far below the current price). If it’s not worth buying under that assumption, it’s perhaps not worth buying.

Finally, avoid at all costs any attempt to speculate on exactly when the bubble might burst. It might be tempting to either try to ride it higher and exit before the peak… or to try profiting from a decline by short selling. Either approach involves taking significant unnecessary risk… like sailing through a storm with a broken compass when you could instead wait for conditions to normalize and your compass to be repaired.

Even the world’s best economists and market analysts struggle to successfully predict how far a bubble can inflate before it runs out of momentum and eventually bursts. The safest way to navigate bubbles is to avoid them altogether.