A bit of theory on asset bubbles

Analysis - 1/23/2018

In short
  • Low interest rates make fertile ground
  • Human nature plays a not inconsiderable part as well
  • Every bubble is unique but they all have the same structure

From the South Seas Company in the 18th century to the subprime panic in 2008, countless asset bubbles of all sizes have wrought an equally wide variety of consequences.

New ones are likely to punctuate our lives as investors. Can they be predicted? What are the mechanisms at work?

Although asset bubbles are simple to define it is not easy to see them forming

What is a bubble? On paper the definition is simple: a bubble occurs when the value of an asset is totally disconnected from economic reality. In the case of a stock, this happens when nothing in its price level reflects the underlying company’s earnings growth.

And yet, it is not easy to spot an asset bubble before it bursts. This is simply because gauging an asset’s “maximum” value is a complicated business. According to the economist André Orléan, “The difficulty lies in the very nature of this value, being an entitlement to the future return on the underlying asset or, in other words, an expectation of what is to come—itself fraught with fundamental uncertainty”.

Here  are  a  few  examples  of  attempted  alerts regarding the risk of an asset bubble popping:

  • In 1996 Alan Greenspan, then chairman of the US Federal Reserve, delivered a famous speech in which he warned of the markets’ “irrational exuberance”. He said that a bubble was forming in US equities and that a correction would come. At the time the S&P 500 was trading at a P/E (price/earnings) ratio of 17.8x. But the New York stockmarket did not collapse until early in the year 2000, by which time its P/E had soared to 26.9x.
  • In July 2006 Henry Paulson, the US Treasury secretary, was worried that the American economy might be heading into a stormy period. He gathered a team of advisers from his department, the Fed and the SEC (Securities and Exchange Commission) to spot early signs of trouble. Together they conducted an in-deptch analysis of US banks and hedge funds… Sadly, these experts failed to see what from today’s perspective should have been obvious: the makings of a chain reaction in the US real estate market leading to a major financial meltdown.
  • In the same vein we could also cite Julian Robertson, manager of the legendary Tiger Fund, which was forced to shut down in early 2000 when its clients fled upon finding out they had lost 19%. Robertson, believing that dotcom stocks were grossly overvalued, had decided to sell the sector short the previous year.


Bubbles and bubbles:

  • The asset in question exerts enormous leverage so that, when the bubble bursts, it brings down a good part of the economy with it. This is often the case with real estate (e.g. the 2008 subprime crisis).
  • The asset has little knock-on effect so that, when the bubble bursts, only the unfortunate investors are hurt (e.g. dotcom stocks in 2002).


The formation of an asset bubble requires certain credit conditions and a herd mentality

Many studies have been carried out on asset bubbles and two books, by Charles Kindleberger1 and Hyman Minsky2, are considered the leading reference works. Both authors agree that every bubble is unique but that they all have the same structure. 

The main prerequisite for the formation of a bubble is easy access to credit. Low interest rates are therefore fertile ground.

This becomes the basis of a process in which human nature does the rest. Modern society is good at fomenting mass illusion and creating large-scale infatuation and panic. Moreover, each generation has an annoying tendency to repeat the errors of the past.

Minsky identified five stages that recur in all asset bubbles:

  • A new paradigm is “discovered”. However weak or solid the innovation that gives rise to the resulting asset bubble, it fosters the belief that a new order is taking shape in which the old rules no longer apply.
  • An expansion phase follows. Initially the price of the asset rises slowly but the ascent gains pace as new investors, afraid of being left out in the cold, enter the fray. This is when the media start to talk and write about the subject, creating a buzz.
  • Then comes the exuberance. Caution is thrown to the wind. Participants extrapolate on recent gains and start pricing in extravagant future returns.
  • The asset price steadies. But this is only a breather before it surges again. Some better-informed players start to sell but are replaced by new joiners.
  • The asset finally starts to fall in price. This is generally triggered by a specific event such as a given company going bankrupt or new regulations being issued. Sooner or later the most recent joiners, gripped by panic, scramble to liquidate their positions. Those who borrowed to buy the asset are forced out of the game, touching off an even faster price fall. This is the Minsky Moment.

Although it is not easy to spot an asset bubble, a number of signs can catch one’s attention:

  1. investors seem complacent, explaining away the asset’s price with ever weaker arguments such as “this time is different”;
  2. often the ratios and other calculations used to measure the asset’s valuation are adapted to fit the situation;
  3. finally, leverage is used increasingly to buy the asset and investors typically assume more risk than they would normally do.


« Participants extrapolate on recent gains and start pricing in extravagant future returns. »
Muriel Tailhades - Chief Investment Officer
Edmond de Rothschild (France)


The pursuit of ever higher returns inflates the bubble

Keeping the cost of money low over a protracted period has consequences. Besides driving up the prices of certain assets that are bought on credit, rock-bottom interest rates can lead to excessive risk-taking.

  • Investors, unable to accept the new level of yields, start going out on a limb to obtain what they were used to in the past.
  • By doing so they push up prices while reducing volatility, thereby distorting the usual measures of risk.
  • Real risks are misjudged and more and more participants wade into risk assets.


Adapting one’s yield expectations and portfolio

Central banks continue to call the tune and are forever repeating that interest rates will stay low for a long time to come. But although the resulting “manipulation” of asset prices could indeed last, some assets are already trading at the top end of their historical valuation range.

When mapping out an investment strategy in the conditions we have just described, one has to bring one’s yield expectations up to date. Moreover, we cannot stress enough that one should gauge the downside risk one’s portfolio and guard against raising its average risk level. Finally, diversifying across asset classes and strategies (e.g. by including convex as well as concave instruments) is more than ever a prime consideration.

Muriel Tailhades
Chief Investment Officer
Edmond de Rothschild (France)


1 Manias, Panics, and Crashes: A History of Financial Crises, 2005.
2 Stabilizing an unstable economy, 2016.

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