What is a Bubble?

What happens when the stock market turns into a casino – and what to do when it does

Andrew Willis 8 October, 2020 | 2:48AM

Bubble 3

Financial bubbles are a lot like soap bubbles at kids’ parties. People gather around, have a great time, and go home happy. Except when financial bubbles pop, almost everyone is surprised, sad, and goes home poorer. But why? Shouldn’t people know that bubbles always pop? Not when they don’t believe it’s a bubble.

“Stock market ‘bubbles’ are difficult if not impossible to predict. Unfortunately for investors, they are only observable after the fact,” says Ian Tam, Morningstar’s Canada’s Director of Investment Research.

Bubbles come in all shapes and sizes, and pop for different reasons. A bubble could be as small as one single asset, like a single company’s stock, or could make up an entire sector, or economy. Or real estate, like houses or condos. The only commonality is that the conviction of future returns is wishful thinking – and by the time most people find out the truth, the bubble has popped.

Let’s start with what we know.

Too Happy
That ‘truth’ in the world of finance is intrinsic value, or what a business or market is actually worth. It’s kind of like the opposite of a bubble. It’s considering every future strength and weakness, and coming up with a value now – and it’s very hard to pin down precisely. 

“If we could see what the future cash flows would be over the next 100 years – and then could discount that back at the appropriate interest rate – that would give us a number,” ventured legendary value investor, Warren Buffett, at a 1997 Berkshire Hathaway Annual Meeting. How often do you think the market gets that kind of math right?

Tam points to the growth of the Canadian stock market compared to its earnings. Notice a departure?

Canada earnings compared to stock prices

“From a fundamental perspective, one would think that if valuations are exceedingly high, the market will tend to correct itself, but we can see that though there have been some instances (like the dot com bubble) where high valuations seemed to precede market corrections, there are just as many cases where this didn’t happen,” explains Tam.

Part of the reason that bubbles are so unpredictable is that they are based on something irrational. What do earnings matter if something priced $1 becomes $2, and then $5 or $10? Who’s to say you can’t sell it at $15 later, or even $20?

“The only reason for putting cash into any kind of an investment now is because you expect to take cash out,” Buffett emphasized at the AGM, “not by selling to somebody else, because that’s just a game of who-beats-who [speculation], but by what the asset itself produces.”

When the true value of something is unknown or overcome, the bubble begins to form. But why? Cheap and easy debt? Fear? Greed? The exact cause is likely to vary with each bubble. But every bubble follows a cycle.

Bad Math and a Game of Chicken: How it Happens
Economist Hyman P. Minsky outlined the five stages of a typical credit cycle in his book, Stabilizing an Unstable Economy (1986). Bubbles can follow a similar pattern.

Displacement
Something new enters the picture. In the case of credit, it could be the introduction of lower interest rates, which can have a fundamental impact on the demand for things like mortgages, which in turn can drive up home prices (which drives up demand, and so on). Or a new technology enters the picture and changes, or ‘disrupts’, a previous technology. Wars…pandemics, somethings gets investors excited and shocks the system. How will this affect their portfolios? What are they missing?

Boom
Now we have an increasing number of investors rushing to come up with the same calculation that Buffett suggested earlier: what could this new thing generate? Media attention grows, social media gets busier and the price of the asset begins to pick up the pace. The investment is seen as a rare opportunity, and that makes the potential rewards harder to estimate and seem limitless. Enter ‘fear of missing out’, or FOMO, a powerful force. Now more investors are willing to take more risks. As this sentiment gains momentum, so does speculation.

Euphoria
By this point, accusations of ‘who-beats-who’ strategies are met with rationalizations. More comfortable metrics and facts are used to address concerns around sky-high price-to-earnings ratios and other valuations. Investors are hooked. “The mania around certain stocks, such as Tesla, is bringing back many comparisons to 1999. That was another market that saw an increase in retail investors chasing new themes and technologies,” says Greg Taylor, Chief Investment Officer at Purpose Investments. “No one knows how far this will run, but most of us remember how 1999 ended.” He admits that some technology stocks may actually be reaching their previously high valuations. Sometimes hype becomes a self-fulfilling prophecy, which in turn makes bubbles even harder to spot and adds to their mystery.

Profit-Taking
But everyone knows unicorns are rare. And cheap debt doesn’t last forever. “The price action of both Tesla and Apple in August following a 5:1 stock split (Tesla up 74.2% and Apple up 21.7%) is a rare occurrence,” says Taylor. “But when it’s happening with the largest car company in the world and another of the top 10 on the S&P 500, it’s hard to ignore and needs to be watched very closely. Tesla is quickly becoming the company that best represents the current euphoria around stocks; it’s the canary in the coal mine.” Taylor is discussing a purely mathematical change to a stock’s price structure, with no actual underlying change in the company’s business. “Once the current debt deferral and relief programs end, the training wheels will be off the economy and we will finally be able to understand what has really occurred in the last year.”

Panic
It could be an idea, a single event like a bankruptcy or a collection of small events, like mortgage defaults, or a Reddit meme that causes a collection of Robinhood accounts to all sell a stock at once. I made that last one up, but who knows: it’s different every time! Domino effects then happen in the market, where for example a small drop then sees investors forced to sell because they were borrowing that money they invested, and now need to get out at any price. The plunge in asset values can in fact be similar to what we saw this spring: market-wide, double-digit losses that can happen in days, and continue for months. But depending on the size of a bubble, asset values can also take years to recover, if at all.

Financial bubbles sound like scary stuff, but are they worth worrying about? The steps above may mirror much of what we see today, and we may be at ‘Step 4’. But then, when would ‘Step 5’ happen? It could be next year, or ten years from now. Or never. 

And if you’re an individual investor with a long enough road ahead, it might not matter. 

“One thing is clear though, the index over the last 35 years has decidedly moved in a positive direction. It is this line that you should be paying attention to in that over the long term, equities are expected to grow, but not without significant bumps along the way,” says Tam. “Instead of speculating about market bubbles, it may be more worthwhile thinking about your time horizon and risk tolerance.”

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About Author

Andrew Willis

Andrew Willis  is Content Editor for Morningstar.ca

 

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