Guarding against the Next Potential Bubble

By David Waddle, Brian Haugen, and Steve Cann

In finance, the term “bubble” generally refers to a situation where the price for an asset greatly exceeds its fundamental value. As interest in the asset/sector/position/commodity grows, the price of that particular asset becomes increasingly inflated while the underlying intrinsic value pales. Eventually, the asset becomes so excessively inflated that it collapses under the weight of its own price. At least that is the fundamental sequence of events.

When the human factor is considered, the scenario looks quite different. The asset normally begins its monumental growth from a relatively humble beginning. In fact, the asset is normally quite undervalued and unpopular. Smart investors detect the asset’s fundamental valuation and the asset slowly gains in price and momentum. This tends to garner some attention and the masses begin to buy in. Popularity ensues and the pricing soon rockets past its proper valuation. Since everyone loves a bandwagon, the popular position soon soars. Eventually, people are leveraging their other assets in order to buy more of the asset at the elevated prices. Finally, when it seems that everyone is “all in” on the position—when no one is left to buy—it falters. Almost instantaneously, it is obvious that the price cannot withstand the valuations and suddenly the price collapses under its own weight.

Examples of bubbles are plentiful. Perhaps the earliest example dates back to the seventeenth century and the Dutch tulip mania. To this day, the Dutch tulip bubble of the early 1600s remains the quintessential yardstick by which speculative bubbles are measured.

Smart investors detect the asset’s fundamental valuation and the asset slowly gains in price and momentum. This tends to garner some attention and the masses begin to buy in.

The mesmerizing beauty of high-grade tulips, combined with the long years it takes to grow them, led to rising prices as the Dutch tulip fad began. Tulips became symbolic of wealth in Holland, and the wealthy became increasingly willing to pay higher prices for them. By February of 1637, prices peaked at levels that were more than ten times the annual income of many Dutch workers. Then suddenly the bubble collapsed, sending prices plummeting to a mere fraction of their peak value.

While the tulip price appreciation and depreciation exhibit an extreme, there are more realistic and recent bubbles we’ve faced in our day.

Tech stocks began to garner attention once the survivors emerged from the first computer companies of the ’80s. Soon, the Internet revolution was well on its way in the ’90s and with it came the bubble of the decade. As the tech bubble reached its climax, relatively unknown companies with absolutely no earnings and huge debt were trading at share prices that were mind numbing. Joe Blow was suddenly a tech guru as he seriously considered making day-trading his full-time job. I recall a client of ours who would take sick time from work just to day-trade from the house! At the turn of the twenty-first century, just as it appeared that the bubble would keep inflating, the “dot-coms” became soon and forever known as the “dot-bombs.”

I was going to mention the real estate boom and bust. But, I was told that subject is still too sensitive for many of us along the Emerald Coast! We’ll have to save that story for some other time perhaps.

Protect Yourself. Know the Symptoms!

Economist Hyman Minsky identified the five common stages of a bubble: displacement, boom, euphoria, profit taking, and panic.

Displacement occurs when investors become enamored with a market transformation and start “justifying” a new paradigm to friends, family and, well, everyone at the cocktail party. This displacement in the marketplace seems to provide logical justification to invest in a particular asset. Boom is how the price appreciates—slowly at first—and then it just skyrockets as more investors seek to “get in.” Often, the quick escalation of price provides further evidence to the investor that “now is the time to buy—before it’s too late.” During the euphoria phase, new valuation metrics are created in order to properly justify a sustained rise in asset prices. Eventually, smart traders begin liquidating, and the profit-taking phase kicks in. The profit-taking phase will likely go unnoticed at first, until the remaining pool of speculative buyers is exhausted and prices start dropping. By the time a clear downtrend in prices is established, panic sets in as investors “rush for the doors.” This selling stampede becomes self-reinforcing, and the asset price plummets.

Becoming familiar with the emotions that surround a bubble is perhaps as important as understanding the fundamentals of an investment. As they say, “If it looks too good to be true, it probably is.” Where or what is the next bubble? We keep our eye on several areas of caution. One area of concern might be exchange-traded commodities/funds/notes. These relatively new investments create a vehicle for Joe Blow to access sectors previously unattainable to the common investor. Keep in mind what John Maynard Keynes once said, “The markets can remain irrational far longer than you or I can remain solvent.” With that, watch out for sectors with booming prices and look out below!

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Prepared by David Waddle, Brian Haugen, and Steve Cann of Emerald Coast Wealth Advisors of Raymond James and Associates, which specializes in designing personalized, diversified financial portfolios for high-net-worth investors along the Emerald Coast.

Past performance does not guarantee future results. There is no assurance these trends will continue. Investing involves risk and you may incur a profit or a loss. Raymond James & Associates, Inc. is a member of the New York Stock Exchange/SIPC.