There is nothing in markets quite like the exhilaration of a speculative bubble’s rise and the panic and depression of the burst. In last month’s commentary, I discussed how a prolonged period of negative interest rates causes financial price distortion as investors borrow, leverage and move out of cash into other assets. I believe this dynamic will increase the frequency and magnitude of asset bubbles across the world. In this commentary, I’ll lay out some thoughts and provide some historical perspective on speculative bubbles.
The price of all assets is driven by two things: 1. the amount of assets available 2. the quantity of money chasing those assets. The quantity of assets tends to be relatively stable and changes steadily – it takes time for new companies to start and real estate to develop, oil and other commodities are mined at a relatively stable rate. Below I show again the rough breakdown of the $500+ trillion worth of assets across the world.
While the quantity of assets is relatively stable, the amount of money chasing those assets can swing dramatically. Our purchasing power consists of available cash and credit that we can call upon. In our financial system, credit tends to be the dominant driver of total purchasing power and the amount of credit can change very quickly (e.g. putting a cash down payment for a much larger amount of credit to buy a house). When people in aggregate borrow more, more money chases the same set of assets and prices go up. The quantity of money/credit is the main driver of short-term price volatility and speculative bubbles.
In today’s low/negative interest rate environment, investors are incentivized to borrow at historically low rates and pump money into stocks or real estate or anything else that might yield a better return than cash. The rapid creation of new credit leads to a price appreciation without improving fundamentals, and can trigger the herd mentality of a speculative bubble. Low rates over the last decade have already caused stock/housing/commodity bubbles acrossthe world.
As I’ll show in the historical examples below, China in the last decade has been a particularly fascinating case study of the impact of credit creation on speculative bubbles. Since 2007, the amount of credit in China has quadrupled from $7 trillion to $28 trillion. Because of China’s capital controls, the pent up pressure from the enormous increase in money couldn’t be released, so huge flows of money ended up swirling violently from asset to asset. In the last 10 years, China has already seen 2 burst stock bubbles and we are likely in the midst of a real estate bubble. A similar dynamic of credit creation is happening all over the world. Since 2007, the world saw a $57 trillion increase in credit.
Some historical examples
I believe speculative bubbles are as fundamental a part of the markets as greed and fear is to human nature. Bubbles were around hundreds of years ago and will likely be here hundreds of years in the future. To provide some perspective, I’ve aggregated some of the more famous bubbles in recent and past history. In the chart below, I show asset prices during the rise and burst of some famous bubbles. The price here is shown as a multiple of the price at the start of the bubble. So for example, the Tulip Mania of the 1600s (the orange line) saw an incredible 50 fold in price. At its price peak, a single tulip bulb sold for the equivalent of $60,000 today. The blue and green lines show the rise and fall of the Mississippi and South Sea Bubbles. Neither was as dramatic as the Tulip Mania, but they saw an impressive 18X and 11X price multiple, respectively. I won’t go into the incredible stories behind each of these bubbles, but they are worth a read.
Asset bubbles after 1900 were too numerous to distinguish on this chart, but I included them as grey lines to provide context. They say history always repeats itself. Bubbles are certainly still very much a part of our markets, but since the 1900s, we’ve managed to avoid the incredible valuations we saw in the previous paragraph (in the major markets at least).
Below I show in table format the relevant information about the bubbles in the above chart. I’ve sorted the table in descending order by peak valuation. The column to the right shows the total drop from peak price after the bubble burst. The 4 columns to the right of that show the duration as well as the rate of the bubble’s rise and fall.
A few observations:
- Of the major bubbles in the last 100 years, oil in 2008 saw the biggest rise while stocks in the Great Depression saw the biggest drop.
- The highest valuation of a major stock market was the NASDAQ in 2000 at 6.6 multiple of starting price, not surprisingly. This is closely followed by the Roaring Twenties, the Japanese Bubble of the 80s and Chinese stocks in 2007, all being around 5.5X.
- The US stock markets today are about 2.8X of its 2009 lows, compared to the 2008 US stock markets peaking at about 2X the 2003 lows.
- The less liquid markets such as real estate tend to see their bubbles grow more slowly but for an extended period of time. Similarly, their price drops also tend to be slower and of longer duration.
- Partly because of the amplifying effects of isolation imposed by capital controls, bubbles in China rise particularly fast – China’s 3 bubbles in the last 10 years are the only ones since 1900s to see prices doubling every year. Of particular interest is the doubling of Chinese real estate prices (in Shenzhen) since 2014. This rate is far higher than any other historical cases of major bubbles in real estate, which tends to rise in the 10-15% range during bubble years.
- By comparison, San Francisco’s housing prices have risen at a 15% annual clip for the last 4 years, which is in the bubble range when compared to the biggest real estate bubble of the 20th century, Japan in 1980s.
To provide a bit more context, below I zoom in on just stock bubbles since 1900.
Below I show the same chart for real estate.
Speculative bubbles are exhilarating but can ultimately devastate an investor’s portfolio. As much as we all try to get out of the way of an oncoming crash, it is often only in hindsight that we realize we were in a bubble. With everyone in the world reaching for returns and yields, we are in a particularly vulnerable environment. This is why I believe it is more important than ever to properly diversify across assets and regions.
[us_separator]Howard Wang co-authored this article. Howard is a co-founder of Convoy Investments and is responsible for research and portfolio management. Prior to founding Convoy, Howard spent his career in the institutional money management industry, most recently at Bridgewater Associates where he and Robert first met. Howard was part of the investment associates team working with some of the largest and most sophisticated investors in the world, including sovereign wealth funds, pensions, endowments and foundations. Howard received a B.A. in mathematics and economics from Yale University and has been a competitive ballroom dancer for over ten years.
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