We have all heard about financial bubbles. They carry high profiles and quickly make it into the news headlines. Not so many people are aware of bubbles during the buildup phases but everyone seems think that they were self-evident after they burst.
Bubbles have been with us for as long as markets have been around and perhaps longer. Recorded history of bubbles goes all the way back to the south bubble in year 1720, and the tulip mania of 1637 to the recent .com bubble and the real estate mania of 2004-6. Since 1925 there have been more than 30 bubbles.
Despite such a stark evidence of bubbles many financial models like the Efficient-market hypothesis say that bubbles shouldnt even exist or that they are extremely rare events. However, for the last 90 years there has been a bubble every 3 years. And there will be more to come.
There is also a belief that bubbles are unpredictable. Both Alan Greenspan and Ben Bernanke have argued that bubbles are impossible to detect until they burst. However, this is utter nonsense since some people are aware of them and are able to call them out before they burst.
Bubbles build up gradually and they get worse overtime until the problem explodes into a crisis to the surprise of most. Although the problem is predictable the timing of the awaiting burst remains uncertain since it depends on many different and changing variables.
For example the credit crisis and housing bust of 2008 / 2009 was predicted by many savvy contrarians long before the event actually happen. Investors like Peter Schiff, Jim Rogers, and Marc Faber openly warned about the impending disaster. Jim Rogers was telling CNBC and Bloomberg that he was shorting US financial institutions in early 2008.
So why do we get blindsided by bubbles if they are obvious to some people? There are a couple of factors that blinds us to bubbles and they are all psychological:
Over-confidence Almost everyone thinks that a disaster is less likely to strike them than the average person.
Illusion of control We have a tendency to believe that we can control uncontrollable events.
Self serving bias Our brains are programmed to look for evidence that support our beliefs. (All news is good news. If it is bad news it can always be better.)
Shortsightedness We have a tendency of living for today with a disregard for tomorrow.
Over focus on details We tend to stare ourselves blind on the details and miss the bigger picture.
How to spot a bubble?
A basic understanding of the market and market history helps us to spot a bubble. Bubbles change and they dont show up at the same place over and over again but the basic structure is the same. Looking at the big picture rather than focusing on details helps. Bill Bonner offers a few words of wisdom Things that cant go on forever wont! This is particularly true for financial bubbles.
During a bubble you will see a growing amount of people that previously hadnt been in the booming business that suddenly enter the industry. During the .com bubble people were quitting their jobs to day trade stocks and during the real estate mania everybody seemed to want to become a real estate agent.
If you start hearing around you saying things like stock prices always goes up in the long run, or housing prices always goes up, then shut out the rest of the world and do something else because you are probably in the midst of a mania.
How are bubbles created?
Financial bubbles are created by dislocation, either government generated through a change in policy or by a supply / demand distortion in the market, which are creating profit making opportunities. As profit making opportunities are created in a particular sector, resources keep flowing out of other areas and into the new attractive sector and so the birth of boom is created.
However a boom cannot be sustained without credit. Credit is like oxygen to a fire. As credit creation is expanding the boom intensifies. It is the creation of money and credit by banks and particularly central banks, according to the Austrian school of economics that leads to the exacerbation of the boom. As credit flows into the boom it steadily grows into a bubble. The bubble will continue to grow until it reaches a point were credit and borrowing has been exhausted and at that point credit contracts and the boom quickly turn into a bust.
There is also a psychological component to a boom. As prices starts rise people start to see money making opportunity and more and more people join the trend. This is reinforced by peoples inherent herd mentality, over optimism, and a self-serving bias.
Bubbles and busts cause financial hardship. But it is not the bust itself that is the problem that so many people seem to think. The problem comes from misallocation of resources in the prior years that led up to the bust. It is only when the correction occurs that most people realize the misallocation of capital. That is why a bust is also called a correction since it is correcting the problem in the market by bring prices down to sustainable levels.