ARE FINANCIAL MARKETS in a bubble? It’s a question I’ve never liked. I believe stocks and bonds are fairly valued most of the time, which means it’s extraordinarily difficult to beat the market averages and our best bet is to buy index funds.
But at the same time, during my adult life, there have been three key occasions when markets lost touch with reality: Japanese stocks and real estate in the late 1980s, technology stocks in the late 1990s and housing in the mid-2000s. And, no, these bubbles weren’t just obvious in retrospect. At the time, many experts warned that valuations were dangerously high. Those who listened had the chance to get out of harm’s way and thereby improve their financial results.
Should we also be looking to get out of harm’s way right now? I’ve heard people fret that there’s a bubble in bitcoin, special purpose acquisition companies (SPACs), Tesla, large-cap U.S. technology stocks and even the entire U.S. stock market.
That brings me to The Delusions of Crowds, the new book by friend and fellow author William Bernstein. Subtitled Why People Go Mad in Groups, Bernstein’s fascinating romp through history probes both financial and religious manias, including recent examples like the dot-com bubble and the Islamic State. “While religious and financial manias might seem to have little in common, the underlying forces that give them rise are identical: the desire to improve one’s well-being in this life or the next,” Bernstein writes.
Drawing on economist Hyman Minsky, Bernstein says there are four conditions necessary for a financial bubble to form: easy credit, exciting new technologies, amnesia about the prior bubble and bust, and the abandonment of old, prudent methods for valuing investments.
Recall the late 1990s. We had falling interest rates, the rapid adoption of the internet and all kinds of bizarre yardsticks used for valuing dot-com companies, including “eyeballs” and “burn rate.” Meanwhile, at that time, the last great stock market mania—the love affair with the Nifty Fifty stocks in the late 1960s and early 1970s—was a distant memory.
What about today? Do we also have the four necessary preconditions? Credit is certainly easy. Investors also seem willing to overlook today’s rich stock market valuations—or, in the case of bitcoin, no discernible value at all.
Meanwhile, we have enthusiasm over innovations like electric cars and blockchain technology, which might make you wary of Tesla and cryptocurrencies. But it would be hard to argue that online shopping, social media, smartphones and internet search engines still qualify as new technologies, so perhaps we shouldn’t declare a bubble in Amazon, Facebook, Apple and Alphabet (a.k.a. Google).
What about amnesia about the prior boom and bust? We saw the S&P 500 plunge 34% last year, but that bear market was over so quickly that maybe it doesn’t count. That leaves 2007-09 as the last big bust and that, I suspect, has become a distant memory for some.
If you’re like me and uncertain about all this bubble talk, Bernstein offers another set of criteria to consider. Roughly halfway through The Delusions of Crowds, he asks, “Is it possible to spot a bubble in real time?” He goes on to note that financial manias like the Mississippi Company, South Sea Company and the roaring 1920s stock market share four characteristics.
First, financial speculation becomes the primary topic of everyday conversation. Think about the constant chatter about tech stocks in the late 1990s and real estate in 2005 and 2006. Think about this year’s fascination with GameStop, Tesla and bitcoin.
Second, people start leaving their current jobs to speculate. Again, think about the folks who started day-trading stocks in the late 1990s or flipping homes in the mid-2000s. Think also about today’s Robinhood traders, though it seems these folks haven’t quit their day job, but rather merrily buy and sell stocks while working from home.
Third, scorn is heaped on the bubble’s naysayers. Those who questioned the value put on internet stocks in the late 1990s or the wisdom of loading up on real estate in 2005 and 2006 were met with ridicule. Ditto for anybody today who questions the rise in Tesla or bitcoin.
So are we in a bubble today? I posed that question to Bernstein. “What’s peculiar about right now is there are lots of little bubbles—bitcoin, GameStop, the Robinhood phenomenon, SPACs,” he says. “But they’re relatively circumscribed. There’s no mania about investing in the S&P 500 or a total market index fund.”
Indeed, I feel we’re a little too quick to slap the term “bubble” on any asset that’s recently performed well. U.S. growth stocks may have posted handsome gains over the past decade, but value stocks were left far behind and bonds today are offering scant competition for investor dollars. Yes, Tesla’s meteoric rise is unnerving. But historically, much of the market’s return has come from a minority of stocks that post spectacular gains, and Tesla could end up doing for the car business what Amazon has done for retail shopping.
What about bitcoin? Like Bernstein, I think it’s a bubble and I’m staying far away. The good news: Even if I’m wrong, it doesn’t much matter. I don’t need to own cryptocurrencies to reach my financial goals. A globally diversified stock portfolio, backed up by a safety net of short-term bonds, should serve me just fine.