The history of investment bubbles goes back hundreds of years, and with the current dramatic price shifts of cryptocurrencies such as Bitcoin and Dogecoin, new chapters are still being written.
But if a genius such as 18th century science pioneer Sir Isaac Newton could fall victim, modern investors certainly need to be on their toes if they’re to spot a bubble’s tell-tale characteristics and not suffer the same fate.
Here’s what to look out for, plus some salutary tales from the past.
How do you spot an investment or asset bubble?
“There’s only one sure way… and that’s after the bubble has burst,” suggests Joseph H Davis, global chief economist at the investment house Vanguard, in a recent market commentary.
But the essence of a bubble is that, while the fast-appreciating asset in question may seem overvalued, its price continues to rise. Davis says knowing when it has reached its peak is the real challenge, “as anyone who has tried to breathe one last breath into a balloon and found it can accommodate two or three can relate.”
In other words, investment bubbles are easy to predict, so long as you have the benefit of hindsight.
With their potential for stellar, if highly volatile returns, cryptocurrencies such as Bitcoin and Dogecoin are enticing even the most disciplined investors into grabbing a piece of potential money-making action for fear of missing out (FOMO) – an acknowledged key component of the investment bubble process. But what are the other tell-tale signs?
Russ Mould of investment broker AJ Bell says: “One way to judge whether something is a bubble or not is to follow the classic cycle of bubbles outlined by Charles P Kindleberger in his magisterial history of financial mayhem,Manias, Panics and Crashes,” before pointing to several key phases:
- The starting points are cheap credit and the prospect of a fabulous, new investment opportunity that offers the prospect of big gains – anything from tulip bulbs to railroads to Japanese property to technology stocks will do if the mood is right
- Initial price rises then catch the attention of newcomers, as FOMO starts to gather
- Investment profits go into orbit and fresh money is attracted, often in the form of borrowed cash
- Copy-cats and imitators appear and more credit becomes available as asset prices keep rising
- Trouble starts. Insiders start to lock in their profits by selling at elevated prices. This leaves the last investors to get in holding the bag. Prices initially correct but then rally as loyal supporters ‘buy on the dips’
- A new offering goes wrong and the queue of copy-cat flotations and management teams looking to sell their stock lengthens. Supply begins to outstrip demand and asset prices fail to reach their previous peaks.
- Then comes a scandal, in the form of a fraud or bankruptcy. Investors realise they have been had and their money has gone
- Fear and revulsion replace greed, asset prices collapse as investors scramble to cut their losses and the blame game begins.
History’s best-known investment bubbles
Tulip mania
Tulip mania came to a head in The Netherlands in 1637 and is often cited as the first financial bubble to have wide-ranging impact. The seeds of the disaster were sown in preceding years – a period known as the Dutch Golden Age because of the country’s pre-eminent international standing and reputation for commerce.
Tulips, originating from the Middle East, had taken on a luxurious, must-have status driving up the price of bulbs to the point where speciality versions took on the same value as entire properties. Individuals who speculated and took part in the buying and trading of tulips became impoverished overnight thanks to an unsustainable situation.
Contracts that had been taken out on future crops became worthless thanks to oversupply. Once buyers became convinced that tulips were overpriced, so their prices tumbled. Amid all the frenzy, few had stopped to think about the lack of intrinsic value the flowers could actually demonstrate.
South Sea Company
Sir Isaac’s bubble woes arose because he staked a fortune on the success of the South Sea Company only to lose heavily financially from the ensuing crash in 1720.
“I can calculate the movement of stars, but not the madness of men,” the scientific colossus complained.
The background to the South Sea Bubble is abhorrent, rooted as it is in the slave trade. The Treaty of Utrecht of 1713 had granted Britain the right to supply slaves, and the South Sea Company was formed to send slave labour to Spanish plantations in Central and Southern America.
The South Sea Company bought the contract from the British government for £9,500,000 (about £2 billion in today’s money), a colossal sum equating to a large proportion of Britain’s national debt. The price was high because the intention had been to secure even more lucrative trading rights with South America once Britain had become an established player in slavery.
The assumption was that profits from slave trading would be enormous, which turned out not to be the case, and the South Sea Company went bust in 1720.
Speculators, including scientist Newton and the author Jonathan Swift, got financially burnt having paid inflated prices for the stock only for the company to suffer its spectacular collapse.
Japanese asset prices
Japan’s asset price bubble came to a head at the end of 1989 having been preceded by a period during which real estate and stock market prices in the country had become greatly inflated.
At one stage, the land under Tokyo’s Imperial Palace was valued as worth more than the entire state of California. The whole episode in Japan was characterised by a rapid acceleration of asset prices, overheated economic activity, plus uncontrolled money supply and credit expansion.
The tale is best illustrated by looking at the performance of the country’s benchmark Nikkei stock market index. At the end of December 1989, the Nikkei hit an all-time high of nearly 39,000, a 900% increase over the preceding 15 years. During 1989, the index had risen by 30% alone but, by the end of the following year, it had plummeted dramatically losing about £1.5 trillion in value.
In 2003, it fell toward 8,000, and when the global crisis hit five years later, it sank as low as 7,600.
Japan’s economic collapse has has long-lasting consequences, and the Nikkei has never come close subsequently to reaching its previous heights. Today it trades 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 businesses, especially in the US – so-called dot.coms – each looking to capitalise and turn a profit from the future of online commerce.
Expectations were unrealistic, however. For every successful company there were dozens of failures, usually ones with unsustainable business models incapable of actually making any money.
In the rush to cash in on the internet boom, investors ignored the fundamental rules of stock market investing at a time when even the most successful players were trading on over-priced valuations.
In the five years to 2000, the US technology-dominated Nasdaq market rose from about 1,000 to more than 5,000. Companies began to fail, however, and the bubble burst with the Nasdaq subsequently tanking to a level below 2,000 by 2002.
Cryptocurrencies – a bubble about to burst?
Recent actions by both Chinese authorities (banning transactions) and Tesla boss Elon Musk (who cited damaging environmental issues linked to computer ‘mining’) have contributed to a 45% fall in the price of the cryptocurrency Bitcoin since it briefly reached $64,000 in April this year.
This has prompted concern among commentators who question whether cryptocurrencies in general, including the likes of Bitcoin’s rivals such as Ethereum and Dogecoin, are contributing to the next financial bubble.
In keeping with bubbles of the past, the ingredients are there: a potential to make money, plus a willing audience.
One of the big differentiators between the bubbles described above and what’s currently taking place in the cryptocurrency sphere is that none of the previous bubbles (not even the dot.com version) played out in the social media age. Word gets around quickly in the 21st century, accelerating both actions and reactions alike.
Cryptocurrencies have certainly enjoyed rollercoaster returns in recent months. On the one hand, fans believe them to be the future of digital money. But critics accuse cryptocurrencies of being no more than vehicles for speculation at best and Ponzi schemes at worst. In other words, fraudulent investing scams.
And you can add into the mix the huge amount of energy involved in maintaining the cryptocurrency enterprise – the issue that concerned Musk.
Chain reaction
On the basis that it’s difficult to spot a financial bubble until after it’s finally burst, it’s probably too early to say whether cryptocurrencies definitively fit the description of one.
There is also the question of the useful by-product brought about by the introduction of cryptocurrencies, namely, blockchain transactions. These are currently of much interest to both financial institutions and central banks alike.
Neither Tulip mania, nor the South Sea Bubble, were able to boast such a potentially useful technological spin-off. Perhaps it will be this consideration that yet prevents cryptocurrencies’ bubble-like characteristics from fully bursting.
