The Six Rules of Asset Bubbles

As the price of one Bitcoin soared past $7,000 yesterday evening, we thought we should dig out the following article from of the archives (originally posted in December 2013) to maintain some perspective. It is our slightly contrarian approach to asset bubbles:

 

The Six Rules of Asset Bubbles

Asset bubbles are highly topical at the moment with bubbles supposedly developing in London property, contemporary art and US shares (among others).

Bubbles are a sign of our times. They have been around for centuries but perhaps we are privileged to have lived through so many in recent years (the Economist last week cited data claiming the number of bubbles has risen fourfold from the 1950s).

We have therefore created the following six rules of asset bubbles to help you spot them (or, just as good, spot when there isn’t one).

 

RULE 1: If you think it is a bubble, it probably isn’t
This is the most important rule in our view, yet perhaps the most counter-intuitive. If you can get your head round this, then the rules that follow will make more sense.

 

Bubbles are notoriously hard to spot at the time. If it were easy, then we would all be making millions buying as the bubble inflates and selling just as it pops.

 

So if you think to yourself “this must be a bubble,” ask yourself: “what do I know that everyone else doesn’t?”

 

The rationale for this rule is simple: if everyone thinks prices are too high, then why are there still buyers? In an efficient market, the price would surely have dropped by now.

 

RULE 2: Bubbles will inflate and deflate much further than you think
When prices are looking uncomfortably high, in our view that is exactly when they are most likely to go higher.

 

This is an extension of ‘anchoring,’ which we have highlighted as a behavioural bias in our June edition. Anchoring is the tendency to attach irrational significance to certain numbers (e.g. round numbers, or the price paid for an investment).

 

Often the only reference points we have are previous prices, and these can be distracting. When the market is rising, the natural tendency is to want to sell. When prices move higher, these sellers then turn into panic buyers – pushing prices higher still. The reverse is true in a falling market.

 

RULE 3: The bubble will only ‘burst’ when everyone thinks it cannot
The final casualty of a bubble is logic. This harks back to what Sir John Templeton called the four most dangerous words in investing: “This time it’s different.”

 

The bursting of a bubble is often accompanied by some claim of ‘a new paradigm’. James Glassman famously wrote “Dow 36,000” in 1999 (with the Dow at around 12,000; it has only just breached 16,000 fourteen years later, having dipped below 7,300 within three years of the book’s publication).

 

RULE 4: Bubbles don’t make people rich
While you might think of examples to the contrary, most investors don’t make money from the rise and fall of asset bubbles. In fact, most investors get swept up in the hubris and jump in at the top, often with disastrous results.

 

While John Paulson, the hedge fund manager, famously made billions from predicting the collapse in exotic derivatives based on US mortgages in 2008, he has fared particularly badly ever since. And when one looks back, it is easy to find economists who claim to have predicted a crisis and are thus portrayed as prophetic.

 

There will always be some exceptions, but in fact it is surprising how few exceptions there really are. Even the professionals get carried away and the success stories rarely outnumber what can be attributed to luck.

 

RULE 5: Afterwards, it will all seem so logical
It is easy to get swept up in bubble mania. However, when the dust settles, the temptation is to post-rationalise it all.

 

While it will all make more sense with the benefit of hindsight, it would be wise to remember that no one really saw it coming.

 

In a recent poll by ING eZonomics, 43% of respondents claimed: “Looking back, I feel like I knew the global financial crisis was coming.” Only 27% admitted they did not see it coming; the rest were “not sure.”

 

RULE 6: Like Underground trains, there will be another one along in a minute.
But it is important to bear in mind that it will probably appear where you least expect it. The more people go looking for bubbles, the harder they are to find.