Boom, Boom, Plop: How to Spot an Assets Bubble

In the aptly titled book Extraordinary Popular Delusions and the Madness of Crowds, author Charles Mackay notes how John Law, the 18th Century Scottish financier whose Mississippi Company gave the modern world one of its first asset bubbles, forgot his own dictum — “a banker deserved death who made issues of paper without the necessary funds to provide for them.” The result? Shares of Mississippi Company started in 1719 at 500 livres (the French unit at the time), shot up to 10,000 livres and sank back to 500 livres in less than two years. Law himself died a lonely death in 1729, banished by the very public that had hailed him a hero just a few years earlier.

Incredibly, even after 300 years and many more bubbles that have resulted in “the impoverishment of many a fool, and the enriching of many a rogue,” few have followed Law’s maxim. The last decade itself has spouted two — the Internet bubble around the turn of the millennium and the housing blob that collapsed in 2008. Maybe it is just greed that drove bankers, entrepreneurs or plain scoundrels to create these money-making air balls and prick them when they had made the most of it. But what about the common investors who have always ended up losers? For instance, in the US, which has been home to the creators, losers and winners of these two bubbles, the middle class lost nearly half the net worth it had accumulated in the previous 30 years, says Eric Janszen, who founded advisory company iTulip in the midst of the dotcom bubble.

 

Illustration: Malay Karmakar

For the average investor, therefore, spotting a bubble could prove a life-saving trick. But how does one do it?

Hong Kong-based finance writer Stephen Vines in his book Market Panic writes: “The more generally understood definition of a bubble relates to situations in which markets bestow exceptionally high valuations on assets.” These valuations far exceed the long-term mean of the security in question and lose any connection with fundamentals.

Arun Kejriwal, who runs Mumbai-based advisory firm, Kejriwal Research and Investment Services, calls “fad, fear and speculation” the three pillars of an asset bubble. So, when a root of tulip that caught the fancy of the Dutch middle-class in the 17th century and went on to cost up to $100,000 in today’s prices, or an ounce of gold that touched the $850 mark in 1980 ( $3,000 per ounce in today’s prices), one could reasonably say it was a bubble. Just imagine the predicament of that Dutch businessmen whose $75,000 tulip was accidentally eaten by a guest who thought the flower was an exotic appetiser!

Bubbles bloat up with the help of two air pumps: Liquidity and leverage. Cheap credit and a lot of money floating around invariably accompany those stratospheric journeys. And while everyone believes the good times will last forever, naysayers are dubbed party spoilers. And even sceptics are often sucked into it sooner or later.

“Because everyone wants quick money and when your neighbours and friends are making loads of it, it is difficult to sit idle,” points out Puru Saxena, who runs a wealth management firm in Hong Kong. “Always remember it is a bubble when people start leaving their day jobs to become full-time investors,” he says.

It is not for want of insight that many “smart” investors fail to identify a bubble. Well, says Janszen — “Bubbles can be hard to spot if one is rewarded for not spotting them.”