We believe bubbles in markets or the economy are aberrations—as if they are “black swans” that descend upon us out of nowhere. That’s not the way the world is. Bubbles are common and very much a part of the normal behavior of markets. A market where the price of almost any stock equaled the discounted present value of expected future dividends and never moved more than what could be justified by changes in expected dividends or the discount rate would be strange. Investors look for stocks, bonds, commodities or other investments where profits can be made as prices move, not where prices are locked to values. Bubbles can lead to outsize returns, or losses.
The prevalence of bubbles and the absence of prices tied to dividends, earnings and discount rates make investing with indexes attractive. Besides being lower cost, index investing is attractive because bubbles are hard to recognize and even harder to predict, so picking the right stocks is difficult. Further, given how fickle a bubble can be, investors seek the protection offered by the diversification inherent in broad market indexes.
History confirms that bubbles are with us more often than not. The housing bubble dominated the decade just ended, and its fallout is all too well known. Before housing, we had the technology and telecom bubble in the 1990s, when everyone thought the Internet would create profits out of thin air. Roll back another decade to the 1980s when markets surged as interest rates and inflation tumbled, producing a double bubble of bonds and stocks. The 1970s saw both inflation and a love for anything that looked like an inflation hedge: gold, real estate and REITs. Corrected for inflation, the all-time high price of gold was set long ago in the 1970s bubble. The 1960s, dubbed the “go-go” years, saw conglomerates and the Nifty Fifty. We could continue to walk back through history, finally reaching the beginning of financial markets that would be recognizable to today’s investors in 15th-century Holland. The bubble then, in 1637, was in tulip bulbs.
Before leaving history aside, one should note the dark side of bubbles: They usually end with market declines and weak economies. The Great Recession of 2007-2009 is the most recent example. After the 1990s tech boom, the market dropped about 50 percent; the 1980s bull market dropped 20 percent from late August to mid-October in 1987, and then crashed another 20 percent in one day on Oct. 19, 1987. The 1960s go-go years ended with the deep recession in 1973-1975; the 1970s inflation was squeezed out of the economy in two back-to-back recessions in 1980 and 1981-1982. Bubbles offer investment opportunities for some, but risks for all.
If bubbles are common and prices don’t constantly align with the theoretical values based on discount rates and expected future returns, what good are the theories of price and value? Although the theories rarely foretell tomorrow’s or next month’s price, they can be a guide to how far the price may be from a reasonable level. As prices—driven by emotions and excitement—rise farther and farther above sensible levels suggested by future returns and discount rates, many find explanations why prices should climb even higher and why the pitfalls of the past might have really been passed. Occasionally, the theoretical values reassert themselves quickly, and more often than not, we get a bubble.