What is a Bubble?
“The world keeps on changing, but there is always something, somewhere, that remains the same.” – Ruskin Bond, author
The world today looks much different than it did 20 years ago. Try explaining the concept of touch screen smart phones, Uber, Social Media, and Amazon (as we know it today) in the year 2000. The world may keep on turning and changing, but one constant can be found in the nature of markets: the law of supply & demand.
Even with advancements in technology and the ease of access to information, markets remain the same. Markets are driven by supply & demand and the beliefs and emotions of investors. While no two events are identical, investors behavior is often similar. Most of the time, investors are rational, and markets are calm. Rarely, like we saw back in March, you see a knee-jerk reaction that results in a trading anomaly- panic selling followed by panic buying. Occasionally, investors experience a euphoria that results in a market bubble.
Bubbles are fun, until they pop. There are many examples of bubble throughout history. Some examples include: the Dutch Tulip Bubble of the 1630s, which saw the prices of some tulip bulbs eclipse the price of a house; the Great Beanie Baby Bubble of 1999, where a $5 plushie would sometimes sell for $13,000 in the secondary market (there’s a comical photograph a couple arguing over a beanie baby collection during a divorce hearing here); and some might remember being mad at their mother for throwing out their collection of baseball cards. Some more famous examples, particularly dealing with the stock market include the Dotcom bubble in 2000, which led to a -80% decline in technology stocks, and the housing bubble that occurred prior to the 2008 market recession.
Market bubbles have occurred over and over again and will continue to occur.
According to James Montier, who is an expert in behavioral finance, the anatomy of a bubble has 5 basic phases:
- Displacement: “exogenous shock that triggers the creation of profit opportunities in some sectors, while shutting down profit availability in other sectors.”
- Credit Creation: “A boom is further exacerbated by monetary expansion or credit creation. As demand exceeds supply, prices naturally increase. Rising prices result in more investment, and a positive feedback loop occurs where new investment leads to increases in income which, in turn, stimulate further investment.”
- Euphoria: This is where “overtrading” occurs that “may involve pure speculation.”
- Critical State/Distress: “Insiders take their profits and cash out. This is followed by an excess of speculators rushing for liquidity.”
- Revulsion: “the final stage of the bubble cycle where people are so badly scarred by the events in which they were embroiled that they can no longer bring themselves to participate in the markets at all.
Now, we don’t want to speculate as to which phase of a bubble we might be in because bubbles can last a long time and it won’t become clear that one is occurring until its too late. Today, many investors actually think that we could be seeing a bubble in the markets right now. According to a recent survey conducted by E-Trade, many wealthier individuals are investing as if a stock market bubble is occurring in some fashion or another. From the survey (found here):
- 9% of wealthy investors think we are nowhere near a market bubble
- 16% think we are ‘fully in a bubble’
- 46% say we are in ‘somewhat of a bubble’
- 29% think that the market is ‘approaching a bubble’
We just went through, and are still going through, a pandemic that shut down the world’s economy. Given that, the markets are higher now than they were at this time last year, prior to the economic shutdown. While small business shut down, people were forced to work from home, and do most of their shopping online. The government was/is writing checks to virtually every middle-class income American, regardless of need. Technology related stocks make up 40% of the overall stock market, larger than it made up during the 2000 Dotcom bubble, and larger than what Financials made up in the markets prior to the 2008 financial crisis.
Market bubbles often do not make logical sense. Go ask a fundamental analyst what they think of Tesla. Tesla is larger in market capitalization than virtually every other car manufacturer combined yet produces a minute fraction of the world’s vehicles. Similarly, very few people understand what a Bitcoin is, let alone how to obtain and liquidate one, yet the price keeps going up at a parabolic rate.
On top of all of this, financial “advice” (mostly not good advice) is seemingly easy to find. Login to a popular social platform among Gen Z and Millennials, neither of which really experienced the Dotcom bubble and the former barely remembers 2008, and you’ll find “educational” stock advice of how some know-nothing can turn $400 into $14,000 in less than a week. In fact, the term “#investing” has hit 278 million views on one popular Gen Z social platform. Just last week, Carole Baskin (from that show, Tiger King) mentioned a penny stock in a video, triggering an increase of 230% in price. To some younger investors, the markets have become a game, much similar to gambling. In the end, it is a game of Russian Roulette. They can win 5 times in a row, but the 6th time blows up the entire program.
Are we in a bubble? Certainly Tesla, bitcoin, and many technology stocks might be in a bubble. Regardless, an investment portfolio must be able to adapt. Adapting does not mean making a prediction about the future and adjusting the portfolio to match that prediction. It is about reading the environment today and building a portfolio to match that environment. We do not know when a bubble will pop, but in the meantime, we can build a diversified portfolio of securities that match today’s market environment.
There are many sectors of the market showing strong characteristics, and not all of them are in the realm of technology anymore, like they have been in recent months. Small-caps, mid-caps, and international equities remain strong. As market environments begin to shift, and they will shift eventually, an Adaptive portfolio, like the Canterbury Portfolio Thermostat will adjust its holdings to match whichever environment comes next… bull or bear.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.