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Understanding Speculative Bubbles

By
Gabe Lembeck
December 6, 2021
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“There is nothing so disturbing to one's well–being and judgment as to see a friend get rich.” Charles P. Kindleberger, author of Manics, Panics, and Crashes

It can be difficult to see a friend get rich, and to “Keep Up with the Joneses,” some people take on high risk with a low probability of success. This effort to take a small amount of money and grow the capital base aggressively is called speculation. Investment, on the other hand, is an effort to grow money relatively slowly in a methodical manner or prevent a lot of money from becoming a little (i.e., creating income or growing the capital base slowly through reinvestment of proceeds).

Several prominent economists have commented on the difference between speculation and investment. Adam Smith, in his Magnum Opus Wealth of Nations wrote that speculation is less about investment and more about a businessman’s willingness to pursue short-term opportunities for profits, which contrasts with a standard businessman who makes consistent longer-term investments in his business ventures. John Maynard Keynes said that while investors look at forecasting the prospective returns of assets over the entire life cycle, speculators tend to look at the psychology of the markets.

Rational Speculation

When you imagine a speculator, you probably envision someone like Gordon Gekko from the movie Wall Street who famously said “Greed, for lack of a better word, is good.” Despite the sometimes negative image portrayed in popular media, speculators are actually a very important part of the market function when they’re acting prudently and taking on calculated risks.

For example, without speculators, we would have a lot of sad farmers when commodities prices plunge out of nowhere. In this situation, farmers have many commodities, whether it’s corn or cotton or soybeans, that they want to sell. Unfortunately, they are unable to sell because the price has plunged, and they will not be able to make a profit. So, speculators will help them out by making bets on whether commodities will rise or fall; by making this speculation, they allow these farmers to hedge out their exposure to commodity crisis.

Irrational Speculation

As demonstrated above, rational speculation can contribute to a healthy market. Irrational speculation, however, frequently devolves into a financial crisis – why?

Some would suggest the Federal Reserve is the driver. There is good reason to suggest that their loose money policy has embedded some speculative dynamics over the last few decades. In our opinion, that is a bit of a recency bias because anyone would be hard-pressed to suggest they are responsible in general for speculation, given that has existed for hundreds, if not thousands of years.

The real driver is very simple: human behavior. Like lemmings, humans like to behave like the crowd. When some people jump, other people say “yes, I’ll fall into that hole with you.” Rewards of the bubble make people cognitively dissonant until the greatest fool buys the product for the highest price. The sequence of events in irrational speculation looks like this:

  • When a novel idea takes hold, demand outpaces supply, so prices rise. A few recent examples of novel ideas are “clicks and eyeballs” or “housing prices have never gone down en masse across the entire country.”
  • To satisfy this increase in demand, producers increase supply. Amazingly, increases in demand stay consistently ahead of the supply increases, and prices continue to ascend.
  • The "new paradigm" takes hold; people who used to distrust speculation now embrace it. The popular consensus is that there's a great reason for the new paradigm, that it's different this time.
  • Markets are no longer efficient. People are buying in the hopes that they can sell to some “greater fool.”
  • Demand dries up. The greatest fools buy, draining the pool of potential buyers.
  • Prices Decline. If you have a very liquid asset, such as stocks, the fall comes very quickly. If it's something less liquid like real estate, then the fall takes more time. Then, we get the reverse situation where everybody else realizes that they spent way too much on the item.
Figure 01. The Life Cycle of Speculative Bubbles
Source: thestreet.com

Speculative Bubbles in History

While people like to blame the Federal Reserve for bubbles, the reality is that this phenomenon has been going on for much longer than the Federal Reserve has existed.

Speculative Bubbles have happened throughout history. Below, you can see some examples from a 375-year period, the early 1600s through the late 1900s. The important point here is that they cover all kinds of geographies and all kinds of assets. We have coins; the famous tulip mania in Holland; lotteries; new companies as IPOs; treasury bonds; real estate; and commodities. Many countries are represented: England, Germany, France. You'll notice from the dates that speculative bubbles happen every few years.

In the United States in the most recent century, there was the speculative bubble in the early 1920s, which led to the great depression. And of course, we know of our most two most recent episodes, the internet stock bubble in the 1990s and the housing bubble in the early 2000s.

Also, consider Japan in the 1980s. There was a bubble in everything, stocks, real estate, art, you name it. They called it the bubble economy. So much so, that, as stocks went up, people bid up real estate, which made stocks go up more. And what's so amazing is at its peak price in 1989, the land under the emperor's palace was worth more than the entire state of California. We laugh at this now, but at the time, people felt that was rational because that's what people do in these moments, they rationalize them.

Figure 02. Selected Speculative Bubbles Throughout History
Source: Manics, Panics and Crashes: A History of Financial Crises by: Charles P. Kindleberger

Conclusion

 

As long as human mind is swayed by greed and fear, speculation will persist. It will start as healthy speculation and transition to unhealthy speculation, leading to the booms and busts that have characterized history for centuries.

 

While Balentine is not necessarily looking for booms and busts, understanding how greed and fear play into financial decisions drives our Tier I process and allows us to remain overweight or underweight equities, as appropriate through our market cycles.

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