Why investment markets always bubble – Forbes Advisor UK

The history of investment bubbles goes back hundreds of years, and with the current dramatic price changes of cryptocurrencies such as Bitcoin and Dogecoin, new chapters are still being written.

But if a genius like 18and While the science pioneer of the century, Sir Isaac Newton, could fall victim to it, modern investors must certainly be on their guard if they want to spot the tell-tale features of a bubble and not suffer the same fate.

Here’s what to look for, along with some salutary tales from the past.

How to spot an investment or asset bubble?

“There’s only one sure way…and that’s after the bubble burst,” suggests Joseph H Davis, chief global economist at investment house Vanguard, in a recent commentary by Marlet.

But the essence of a bubble is that while the rapidly appreciating asset in question may appear overvalued, its price continues to rise. Davis says knowing when he’s peaked is the real challenge, “like anyone who’s tried to breathe one last breath into a balloon and found it could accommodate two or three can figure it out.”

In other words, investment bubbles are easy to predict, as long as you have hindsight.

With their potential for stellar returns, albeit highly volatile, cryptocurrencies such as Bitcoin and Dogecoin entice even the most disciplined investors to grab potential lucrative action for fear of missing out (FOMO) – a key element recognized of the investment bubble process. But what are the other telltale signs?

Russ Mold of investment broker AJ Bell says, “One way to judge whether something is a bubble or not is to follow the classic bubble cycle described by Charles P Kindleberger in his masterful history of financial chaos, Manias, panics and crashes», before pointing out several key phases:

  1. The starting points are cheap credit and the prospect of a fabulous new investment opportunity that offers the prospect of big gains – everything from tulip bulbs and railroads to Japanese real estate and tech stocks. , will do if the mood is right
  2. Initial price surges then catch the attention of newcomers as FOMO begins to rally
  3. Profits from investments are orbited and new money is attracted, often in the form of borrowed money
  4. Copiers and imitators appear and more credit becomes available as asset prices continue to rise
  5. The troubles begin. Insiders begin to lock in their profits by selling at high prices. That leaves the last investors to hold the bag. Prices initially correct but then rally as loyal supporters ‘buy into dips’
  6. A new offering goes awry and the queue of IPOs and management teams looking to sell their shares grows longer. Supply begins to exceed demand and asset prices do not reach their previous highs.
  7. Then comes a scandal, in the form of a scam or bankruptcy. Investors realize they got screwed and their money is gone
  8. Fear and revulsion replace greed, asset prices crash as investors scramble to cut their losses and the blame game begins.

The most famous investment bubbles in history

Tulip Mania

The tulip craze reached its climax in the Netherlands in 1637 and is often cited as the first financial bubble to have a far-reaching impact. The seeds of disaster were sown in the preceding years – a period known as the Dutch Golden Age due to the country’s pre-eminent international position and commercial reputation.

Tulips, which originated in the Middle East, had acquired a luxurious and must-have status, driving up the price of bulbs to the point where specialized versions took on the same value as entire properties. Individuals who speculated and participated in the purchase and trade of tulips became impoverished overnight thanks to an unsustainable situation.

Contracts that had been written on future crops became worthless due to oversupply. Once buyers were convinced the tulips were too expensive, their prices plummeted. In the midst of all this frenzy, few had stopped to think about the lack of intrinsic value that flowers could actually demonstrate.

South Seas Company

Sir Isaac’s bull woes came about because he gambled a fortune on the success of the South Sea Company only to lose heavily financially in the ensuing crash of 1720.

“I can calculate the movement of stars, but not the madness of men”, complains the scientific colossus.

The context of the South Seas Bubble is odious, rooted in the slave trade. The 1713 Treaty of Utrecht had granted Britain the right to supply slaves, and the South Sea Company was formed to send slaves to Spanish plantations in Central and South America.

The South Sea Company purchased the contract from the British government for £9,500,000 (about £2 billion in today’s money), a colossal sum equivalent to much of Britain’s national debt. The price was high as the intention had been to secure even more lucrative trading rights with South America once Britain became an established player in slavery.

The assumption was that the profits from the slave trade would be enormous, which turned out not to be the case, and the South Sea Company went bankrupt in 1720.

Speculators, including scientist Newton and author Jonathan Swift, have been financially burned after paying inflated prices for the stock only to have the company suffer its spectacular collapse.

Japanese asset prices

Japan’s asset price bubble peaked in late 1989 after being preceded by a period when real estate and stock market prices in the country rose sharply.

At one time, the land beneath the Imperial Palace in Tokyo was worth more than the entire state of California. The entire episode in Japan was characterized by rapidly accelerating asset prices, overheated economic activity, and runaway money supply and credit expansion.

The story is best illustrated by looking at the performance of the country’s benchmark Nikkei stock index. At the end of December 1989, the Nikkei hit an all-time high of nearly 39,000, a 900% increase over the previous 15 years. During 1989 the index alone had risen by 30% but by the end of the following year it had fallen dramatically, losing around £1.5 trillion in value.

In 2003 it fell to 8,000, and when the global crisis hit five years later it fell to 7,600.

Japan’s economic collapse had lasting consequences, and the Nikkei never came close to hitting its previous highs thereafter. Today it is trading around the 28,500 mark.

Dot.com boom to bust

The dot.com bubble lasted from 1995 to 2000, coinciding with the internet revolution, which helped create a wave of fledgling companies, particularly in the United States – called dot.com – each seeking to capitalize and profit of the future of online commerce.

Expectations, however, were unrealistic. For every successful business there have been dozens of failures, usually those with unsustainable business models unable to make money.

In the rush for the rise of the internet, investors ignored the fundamental rules of stock market investing at a time when even the most successful players traded at overvalued valuations.

In the five years to 2000, the technology-dominated U.S. Nasdaq market grew from around 1,000 to over 5,000. However, companies began to fail and the bubble burst with the Nasdaq which then fell to below 2,000 in 2002.

Cryptocurrencies – a bubble about to burst?

Recent actions by Chinese authorities (banning transactions) and Tesla boss Elon Musk (who cited damaging environmental issues related to computer ‘mining’) contributed to a 45% drop in the price of the cryptocurrency Bitcoin since briefly hitting $64,000 last April. year.

This has raised concerns among commentators about whether cryptocurrencies in general, including Bitcoin competitors such as Ethereum and Dogecoin, are contributing to the next financial bubble.

In line with bubbles of the past, the ingredients are there: earning potential, plus a willing audience.

One of the big differentiators between the bubbles described above and what’s happening in cryptocurrency right now is that none of the previous bubbles (not even the dot.com version) happened in the first place. era of social media. The news travels quickly in the 21st century, accelerating both actions and reactions.

Cryptocurrencies have certainly had a rollercoaster comeback in recent months. On the one hand, fans see them as the future of digital cash. But critics accuse cryptocurrencies of being vehicles for speculation at best and Ponzi schemes at worst. In other words, fraudulent investment scams.

And you can add to the mix the huge amount of energy involved in maintaining the cryptocurrency business – the issue that concerned Musk.

Chain reaction

Given that it is difficult to spot a financial bubble before its final burst, it is probably too early to tell if cryptocurrencies definitely fit the description of a bubble.

There is also the question of the useful by-product brought by the introduction of cryptocurrencies, namely blockchain transactions. These are currently of interest to both financial institutions and central banks.

Neither Tulip mania nor South Sea Bubble could boast of such a potentially useful tech spin-off. It may be this consideration that will further prevent the bubble characteristics of cryptocurrencies from bursting completely.