On Bubbles, Time and the Ultimate Truth
I’ve always had a keen interest in bubbles. Something about making crazy money and then losing it all (and more) just fascinates me. Further, investors love to misunderstand bubbles. To help make sure I fully understood the history of financial bubbles, I read Boom and Bust: A Global History of Financial Bubbles. This book takes readers on a journey through some of the most significant bubbles in global history, analyzing their causes and consequences. Below are the key bubbles analyzed in the books, which lead to some interesting trends.
- The South Sea Bubble (1719–1720): In the early 18th century, the South Sea Company in Britain captured the imagination of investors, promising substantial profits from trade with South America. However, speculation and mismanagement led to a dramatic collapse, leaving many in financial ruin.
- The Mississippi Bubble (1718–1720): Parallel to the South Sea Bubble, the Mississippi Company in France experienced its own financial frenzy. Spearheaded by John Law, the scheme involved speculative investments in North American trade, ultimately ending in economic disaster when the bubble burst.
- The Latin American Mining Bubble (1824–1826): Fueled by excitement over independence movements in Latin America, British investors poured funds into mining ventures. Unfortunately, many of these enterprises were overly speculative, leading to widespread losses.
- British Railway Mania (1844–1846): A period of unbridled enthusiasm for railway development gripped Britain in the mid-19th century. While some railways proved successful, the speculative frenzy led to a financial crash when projected profits fell short.
- Australian Land Boom (1886–1893): Australia experienced a real estate bubble fueled by speculative land investments. The bubble bursting triggered a severe economic depression that impacted the nation for years.
- British Bicycle Mania (1895–1898): The late 19th century saw a surge in investments in bicycle manufacturing companies in Britain. The market eventually became oversaturated, leading to a collapse in share prices.
- The Wall Street Crash (1920–1929): Perhaps the most iconic financial bubble, the 1920s stock market boom in the United States culminated in the devastating crash of 1929. The aftermath ushered in the Great Depression, leaving a lasting impact on global economies.
- Japanese Asset Price Bubble (1985–1992): Excessive speculation in real estate and stock markets drove asset prices in Japan to unsustainable levels. The eventual collapse began a prolonged economic stagnation known as the “Lost Decade.”
- The Dot-Com Bubble (1995–2001): The rise of internet-based companies led to a speculative frenzy in the late 1990s. While some firms emerged as long-term successes, many collapsed when valuations proved unsustainable.
- The Subprime Mortgage Bubble (2003–2008): High-risk mortgage lending and a housing market boom in the United States fueled a massive bubble. Its burst triggered the 2008 global financial crisis, with widespread economic repercussions.
- Chinese Stock Market Bubbles (2007 and 2015): China experienced rapid increases in stock market valuations during these years, driven by speculative trading. Both instances were followed by sharp declines, highlighting the fragility of speculative markets.
Lessons from Bubble’s Past and How Bubbles End
This analysis demonstrates recurring patterns in financial bubbles: speculative euphoria, excessive leverage, regulatory failures and similar timeframes. Understanding these items can help us understand when you are in, entering or exiting a bubble.
To understand how bubbles are formed, you need to first understand how they form. Boom and Bust: A Global History of Financial Bubbles introduces the Bubble Triangle framework to explain the formation of financial bubbles. This model draws an analogy to the fire triangle—comprising oxygen, fuel, and heat—where each element is essential for a fire to ignite.
- Marketability: This refers to the ease with which assets can be traded. High marketability means assets can be quickly bought or sold, attracting more participants and facilitating rapid price increases.
- Money and Credit: Ample liquidity and accessible credit provide the necessary capital for investors to purchase assets, fueling the bubble’s growth. Without sufficient money or the ability to borrow, speculative investments would be limited.
- Speculation: The pursuit of profits from anticipated price increases leads to speculative buying, driving asset prices beyond their intrinsic values. This speculative behavior is akin to the heat in the fire triangle, intensifying the bubble’s expansion.
Just like fire, if you lose any one of these three items, your fire will go out (aka your bubble will pop). The easiest example here would be credit tightening with rising interest rates (I think that’s what killed the stock/crypto bubble of 2021). It’s a bit of chicken or the egg, but any downward price action can lead to the end of speculation, which can quickly end a bubble.
Don’t Fight the Market (in the Long Term)
I think it is important for investors to understand bubbles. You see so many people ignoring these market dynamics or claiming certain assets have been in bubbles for decades at a time. Generally, when these happen it is usually around controversial assets like Tesla or Bitcoin. You can argue if these assets are overvalued at any point in time, but many use the bubble argument to argue these assets are really zeros if it weren’t for irrational exuberance by the market.
The problem here is you are fighting the market and the market has been telling you that you are wrong. Finding the truth in the markets can be tricky. I tend to be on the side of the markets being efficient in the long term and that we shouldn’t fight them in the long term. Yet, it’s hard to balance that stance with all the bubbles we just quickly ran through. I think the key to find the truth is using the difference of time. The longer an asset remains at an inflated market cap, the less likely it is a bubble. Speculation and easy credit have a short half-life. You can fight the market in the short term, I don’t think you can in the long term.
We need to measure ourselves on different time intervals. If the market has been moving against you for a decade, it’s time to admit you are wrong. Time is the ultimate truth.
