Stock Market Bubbles are Inevitable – Are You Prepared for the Next Burst?

Brian Burton

 

It was our second week of remote work, COVID-19 had just recently been declared a pandemic, and global markets were in a free fall… chaos would be putting it lightly. People across the world were hunkering down and businesses were wondering how to navigate uncharted waters. In the height of the pandemonium, our firm was meeting for our third Zoom meeting of the day, equaling how many times we had ever met via Zoom before the shutdown. The term “bubble” was beginning to be discussed within the financial media, bringing concern to pundits and investors alike.

The meeting that day was our Investment Committee’s routine portfolio/economic review, occurring at a time when fear and panic were gripping global markets. The conversation covered a myriad of topics, went on for hours, and is one that we will never forget. The idea that domestic equity markets were in a bubble and that a global pandemic may be the pin causing it to pop was discussed from all perspectives. Asset bubbles were not new to us, having been through the dotcom and housing bubbles over the past two decades, but this period felt different and drove us to further research the creation, psychology, and finality of the market reaction.  It was a pivotal point for any investor; those who navigated it well were rewarded handsomely, and those who overreacted were unjustly penalized.

 

 

A Brief History of Asset Bubbles

The term “bubble” refers to a situation where asset prices significantly increase in a short period to a point where they cannot be reasonably supported by the underlying fundamentals. There are alternative definitions that seem relevant to today’s activity, like this one from Nobel-winning economist, Robert Shiller, where he defines a bubble as “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors…despite doubts about the real value of an investment, are drawn to it partly through envy of other’s successes and partly through a gambler’s excitement.”¹

Recent examples of asset bubbles are the run-up in technology stocks in the late 1990s and the housing boom in the mid-2000s, but asset bubbles have been around long before the dot coms and KB Homes.

Asset bubbles have been bursting since the Dutch Tulip Mania of 1636 when the plant became a status symbol in Dutch society. Speculators were buying all available bulbs and later flipping them at a profit, causing prices to surge, and eventually collapse. Asset price bubbles like this are to blame for some of the most devastating recessions in history. The stock market bubble of the 1920s, the dot-com bubble of the late 1990s, and the real estate bubble of the 2000s were all followed by sharp economic downturns.

 

The Creation of Asset Bubbles

The fear of missing out, or FOMO, is more prevalent in society today than ever before and is one of the driving forces behind the creation of certain asset bubbles (think Bitcoin). This type of behavior creates demand-pull inflation where the buyers’ demand for an asset exceeds the available supply of that asset causing prices to rise, completely irrespective of its underlying value.

Another key aspect to bubbles forming are central banks around the world and their easy-money policies. The idea is that cheap cash leads companies to invest and hire as rising asset prices make people more confident and encourage spending. The downside is that dramatically enhancing liquidity can lead to the mispricing of assets as these dollars go in search of higher returns. And, with a negative real return on safe assets, investors have flocked into higher-risk securities creating some froth in risk assets.

Asset shortage is another condition that creates an imbalance between supply and demand leading to prices appreciating beyond the asset’s value. This was the case in 2008 when oil prices shot up to a record price of $145 per barrel due to a sharp decline in global oil production, with simultaneous demand growth. This bubble eventually burst later that year with prices sinking to $30 per barrel.

 

The Five Stages of an Asset Bubble

In his book “Manias, Panics, and Crashes: A History of Financial Crises,” Charles Kindleberger describes the five phases of an asset bubble:

  1. Displacement – some sort of shock to the system that creates a new opportunity in at least one sector of the economy. This theme is recognized by early investors and the so-called “smart money” is invested during this stage. A recent example is the adoption of the internet and email in the 1990s that set the stage for the dot-com bubble.
  2. Boom – optimism grows around the theme, prices gain momentum as more and more investors enter the market and the fear of missing out (FOMO) spurs more speculation. This is the stage where the media picks up coverage.
  3. Euphoria – media attention grows, and irrational exuberance takes over as more and more euphoric investors enter the market as they see others getting rich. These new participants extrapolate recent price increases into the future, expecting prices to continue to increase at unsustainable rates and sound investment shifts to wild speculation.
  4. Distress – the “smart money” begins to head for the exits, selling their positions and taking profits. Prices head south, the selling gains momentum as more and more investors sell their positions. This stage can run its course very quickly as it did during the dot-com crisis, where panic happened almost immediately, or it can take much longer for the crisis to fully develop like the Great Financial Crisis.
  5. Panic – Investors run for the hills as everyone tries to get out at the same time. Asset prices plummet, to at times, irrationally low levels as those who bought on margin are forced to liquidate their positions at any price.  The sell-off often spreads to other sectors and countries.

 

The problem for investors is that you can never know how long each stage will last in real-time.

 

Understanding these five phases and knowing they have been present in every asset bubble that has burst in history should make it easy to predict when a bubble is about to pop, right? Just ask the hundreds of analysts that have been calling for a bubble in tech stocks to burst for nearly ten years now: trying to time asset bubbles is easier said than done and is effectively impossible over the long run.

 

Bubbles and Subsequent Contractions Should be Expected

Rising asset prices do not necessarily equal a speculative bubble.  It is inevitable for asset prices to experience cycles, and price corrections are a natural – and healthy – part of them. These highly unpredictable price cycles further strengthen the case for remaining invested in a well-diversified portfolio across a variety of asset classes that do not all move in the same direction. Confidently staying invested through the ups and downs requires knowing your time horizon and having a financial plan in place that factors in the various market cycles over this period. Trying to determine if we are in a sustained rally vs. a speculative bubble can only be done well with hindsight, but for a long-term investor with proper planning, it should not be a question that we lose sleep over.

 

Remaining Calm and Focused During Stressful Times

Back in March 2020 during peak market anxiety, we wrote a commentary titled “Portfolio Management Strategy Amid Market Chaos,” that focused on remaining calm during troubling times.

Here is the opening paragraph from that commentary written on March 19, two trading days before the market bottom: “During periods like this, it is important for all of us to step back, take a breath, and attempt to gain some amount of perspective on what is happening. Just over one month ago, domestic markets were celebrating all-time highs and the economy was cruising. Today, the market is in ‘panic mode’ and approaching an attitude of despondency.”

If you are unfamiliar with the cycle of investor emotions, an attitude of despondency often reflects the point of maximum financial opportunity. Although we were not attempting to call a bottom, we stressed the utmost importance of sticking to a process, remaining calm, and not making decisions based on fear alone.

How to Prepare for the Next Bear Market

Market downturns are nearly impossible to avoid, they are simply a part of investing, and without a proper strategy, these periods can prove quite costly. Unfortunately, many investors feel that jumping out of the market into cash is the best way to combat periods of market stress when instead we need to stay disciplined and be willing to rebalance regularly. It may be uncomfortable at the time but what the illustration to the right shows us is that short-term peace of mind can turn out to be quite expensive.

 

Long-term investors are rewarded with market gains by remaining disciplined during short-term volatility.

 

 Here are a few steps we can take to ensure we are prepared for the next bubble, hopefully lessening the impact of a deep sell-off.

  • Build your financial plan with the full expectation of encountering bear market conditions.
  • Truly understand your risk appetite – how would you feel if your account value dropped by 20%, 30%, 40%? Can you remain disciplined during the most volatile times?
  • Be conservative with short-term money – if you plan to spend it in the next few years it should not be invested aggressively.
  • Understand the risks in your bond portfolio – market downturns often reveal that not all bonds are created equally.
  • Limit your exposure to catastrophic, company, or sector-specific failures by diversifying your holdings across industries.

 

Being properly prepared for a bear market affords investors the luxury of being disciplined when the economic data is daunting and opportunistic when opportunities arise during extreme volatility.

 

Some examples include Roth IRA conversions at a lower tax cost, tax-loss harvesting in non-qualified accounts, rebalancing to purchase equities at lower valuations, and dollar-cost averaging cash into the market.

We were asked several times back in March 2020 if our clients were panicking given the extremely difficult circumstances. To their surprise, our answer was always a resounding no. Our clients are knowledgeable in understanding that the market sell-off would rebound given time. However, a large part of it is that our clients understand how well we know each one of their situations. Clients understand that we have built these types of black swan scenarios into their individual financial plans, and they know we have the proper processes in place to continue to make the best decisions for them no matter the chaos.

 

Are you prepared? Let us help. Reach out to us at (859) 226-0625 or info@ballastplan.com.

 

Ballast, Inc. is a registered investment adviser with the SEC. Registration with the SEC does not indicate that the adviser has achieved a particular level of skill or ability, nor is it an endorsement by the SEC. All investment strategies have the potential for profit and loss. Ballast, Inc. is not engaged in the practice of law or accounting. Always consult an attorney or tax professional regarding your specific legal or tax situation.

 

Sources:

  1. Shiller, Robert J. Speculative Asset Prices.  Prize Lecture, December 8, 2013.  Yale University.
  2. Tulip Price Mania; https://commons.wikimedia.org/wiki/File:Tulip_price_index.svg
  3. DJIA (1927 to 1932); https://www.businessinsider.com/the-stock-market-crash-of-1929-what-you-need-to-know-2018-4
  4. Nasdaq v SP500 (1994 to 2001); https://greenmangotrading.wordpress.com/tag/dot-com-bubble/
  5. S&P/Case-Shiller Home Price Index; https://fredblog.stlouisfed.org/2017/10/incomes-determine-house- prices/?utm_source=series_page&utm_medium=related_content&utm_term=related_resources&utm_campaign=fredblog
  6. Cycle of Investor Emotions; https://www.forexlive.com/news/!/where-are-we-in-the-cycle-of-market-emotions-20200322
  7. Missing Out on Best Day Can be Costly; https://www.fidelity.com/spire/6-tips-volatile-markets
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