Bubbles Through Time

Bubbles have been part of the investment landscape since the early 1600s. The recent real estate and commodity bubbles are just the latest incarnations of the phenomena.

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Throughout history, there have been clearly defined times in which investors ignore available information, such as intrinsic value or acceptable levels of risk, and make — or hold — investments they might otherwise avoid. Such times are often referred to as market “bubbles.” In a bubble, asset prices are driven beyond what many consider rational, only to come crashing back to earth when the reality of intrinsic value — or a reverse in investor sentiment — takes precedence. The current economic crisis, triggered by the recent housing bubble and related increase in subprime mortgage defaults, is an example of an extreme bubble bursting.

Market bubbles are hardly new; countries throughout history and around the world have seen them grow and crash, from the Dutch tulip craze of 1637 to the recent collapse of real estate prices in the United States. As an investor, the question isn’t whether there’s going to be another market bubble. Instead, what’s important is the ability to recognize a bubble when it’s growing, avoid making decisions that run contrary to your long-term plan and position your portfolio to minimize the damage when prices come back to earth.

Be Alert to Hype
In his 2001 paper, “Bubbles, Human Judgment, and Expert Opinion,” Yale University professor of economics Robert J. Shiller says that bubbles, by their very nature, are the result of human behavior as much as anything else, and that every bubble is likely to have a definite shelf-life. “The essence of a speculative bubble is a sort of feedback, from price increases, to increased investor enthusiasm, to increased demand, and hence further price increases,” he says. “The high demand for [an] asset is generated by the public memory of high past returns, and the optimism those high returns generate for the future.” This feedback, Shiller argues, encourages the market to reach higher levels than it would if it were responding only directly to fundamental forces. Once the cycle stops feeding on itself, a collapse can occur, often with devastating effects.

So what can you do to make sure you don’t get caught up in a bubble? “Investors can protect themselves from bubbles by staying true to a long-term investment plan. Stubborn adherence to a long-term plan will often require both emotional and financial discipline, but this fortitude is also usually rewarded when the bubble du jour inevitably pops,” says John Skjervem, chief investment officer for Northern Trust’s Personal Financial Services division.

In addition to maintaining a long-term focus and a well-diversified portfolio, pay attention to the key indicators that a market bubble may be developing — phrases and words like “the new paradigm” or “modern” valuation metrics are often a good clue. Similarly, if historical valuation gauges such as capitalization ratios or price/earnings ratios are off the board, bubble hype could be driving prices beyond the norm.

The Value of Fundamental Analysis
Human nature, and our natural inclinations to follow a crowd and back a winner, can sometimes put you at odds with the fundamentals-based approach your investment advisor likely follows. Although markets contain a host of additional factors that can move an asset’s price up or down, the key drivers of fundamental analysis — measures such as appraised value, sales, earnings, industry strength and market share — can go a long way toward determining an asset’s fair value beyond investor sentiment.

Not all increases in asset prices indicate a bubble, of course. “A dramatic and extended rise in the price of an asset or group of assets can be based on economics, if the factors for a change in fundamental value are present and not just assumed,” says Dr. Walt J. Woerheide, vice president of academic affairs and the Frank M. Engle Distinguished Chair in Economic Security Research at The American College in Bryn Mawr, Pa. “There are cases where it looked like bubbles, but it turned out it was just a major re-evaluation going on,” he says. Such cases include the recent jump in the price of commodities, such as oil, which are driven more by factors of supply and demand and less on pure speculation. What’s important, he notes, is the ability to apply these fundamental factors to determine if future expectations for an asset’s performance are reasonable.

Diversify Broadly, Rebalance Regularly
Despite all of the warnings, bubbles do exist and in the market corrections that inevitably follow their bursting, even savvy investors can feel the effects. And, just like on the front end of a bubble when the desire to get in on the action can be overwhelming, the after-effects of a bubble can easily lead to a hurried panic for the exits.

“There is a lot of similarity between bubbles and panics. They’re very much the same phenomenon, just in opposite directions,” Woerheide says. “In a panic, people think they see incredible disaster, and they start selling like crazy. So whoever is buying at the bottom can become extremely wealthy when those prices bounce back and people realize how oversold stocks have become. In bubbles, it’s sort of the same thing, only the guy that gets hurt the most is the one that buys at the top.” To that point, Skjervem adds, “Condo-flipping recently ended every bit as badly as day-trading did at the end of the last cycle, another reminder that investors are ultimately best served by a long-term investment plan that includes well designed allocations to multiple asset classes.”

For many investors, such a plan is likely to include two key components: diversification and regular rebalancing. Although diversification can not guarantee against loss, by diversifying your portfolio by asset class, investment style, geographic location and industry, you stand the best chance of reducing a bubble’s impact. Similarly, by rebalancing — or working to make sure that no asset class is over- or under-represented in your portfolio — the effects of a bubble in any one class may be minimized.

A Rational Response
For his part, Shiller acknowledges that there are market participants and observers who shrug off the concerns of more prudent investors whenever a bubble is either on the horizon or has already arrived.

In writing about the then-recent bubble in technology stocks, Shiller noted that “[some] sharply disagree with these bubble stories, and it ... seems to them that the high valuations the market has placed on the stock market can be attributed to actions of rational investors who are wrestling with hard-to-interpret evidence. [For these investors], suggesting that investors at large have been irrational seems arrogant and presumptuous.”

But whether some investors think others are irrational or not, what’s clear is that bubbles are likely to be a part of the landscape for a long time. Financial markets are volatile by nature, and there will always be investors seeking outsized gains. The combination of the two has led to bubbles in the past, and will do so again in the future. Recognizing a bubble for what it is and taking the necessary steps to reduce its impact will go a long way in making one more endurable.

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