Anatomy of a Bubble

Gaining the attention of already inundated readers is not easy. While what we write about is our passion, for most of you it’s a pastime. With the division of labor in advanced economies, that’s the way it ought to be. Therefore, we’ll make today’s case as succinctly as we can.

We direct your attention to the chart, extracted from the recently released Martin Capital Management 2021 annual report. The circles note the three principal, exponential, stock-price bubbles since 1900. It is clear what happens after bubbles burst. Markets surprise by plunging well below their mean. The studiously observant might wonder, If markets are efficient and represent the culmination of informed judgments, why are the deviations—both above and below the dotted, best-fit trend line—occasionally so extreme? In short, markets are neither highly efficient nor informed. Bubbles are precisely the countervailing evidence of this reality.

Robert Shiller, in his 2013 Nobel Prize in Economics acceptance speech, offered this definition of a bubble.

A situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.

Shiller aptly described our current environment. The S&P 500 recorded 68 new highs in 2021, the most in more than a quarter century for an annual period. During that year of market headlines, the index rose 28%, creating $8.6 trillion in wealth along the way. For the record, GDP increased 5.6%.

Increasingly, social media have become the most prominent means of contagion. According to Pew research, YouTube and Facebook are actively used by 81% and 69%, respectively, of U.S. adults. The fantastically popular Reddit, which surged in usage from 46 million in 2012 to more than 500 million in 2021, is a go-to site for retail speculators and has attracted the most media attention. The aforementioned MCM annual report, page 4, indicates that the “Reddit Rebellion” is emblematic. As a social-news aggregation and discussion website, Reddit has proven an ideal contagion and feedback-loop vehicle.

Though crypto currencies are not technically investments, they reign supreme as the tip of the speculative-bubble iceberg. Acceptance of the comparatively new concept is surprisingly deep with an estimated 22% of adult Americans owning them. Serving as testament to crypto’s meteoric rise, the sector’s aggregate value has quadrupled over the last year to $3 trillion. Excitement about the possibilities of decentralized finance and non-fungible tokens is growing apace, and meme coins like Dogecoin and Shiba Inu are in the spotlight. The appeal of crypto, we note with a sense of irony, may well lie in its opacity. Unlike traditional investments, crypto currencies have no intrinsic value. Adding further to the mystique, few people understand the technology behind them, and it is difficult to use them as actual currency.

Both envy and greed are indigenous to bubbles. Warren Buffett impolitely observes that bubbles happen because people see their neighbors, “dumber than they are,” getting rich. And nothing motivates like money, which has become many Americans’ sordid symbol of success. No doubt partially traceable to the pandemic, unconstrained online gambling has a worrisome number of Americans anonymously, even addictively, in its grip. Along with apple pie in American cultural staples, the National Football League has taken a bite of this forbidden fruit. With targeted marketing from family-style celebrity spokesmen such as Ben Affleck, Martin Lawrence, and Jamie Foxx, the NFL brought get-rich-quick schemes to the living room. Headliner commercials aired during game broadcasts pitch betting just a click away at WynnBET, DraftKings, FanDuel, or BetMGM accounts. Money talks: The NFL expects to gross $1 billion over the next 10 years from its endorsement.

Back to Equities

Returning to the comparatively mundane—the bubble in equities—it is widely assumed that prices are determined by the interaction of millions of people. From our observations, very few of them have felt the need, or have the capacity, to perform careful research on long-term investment value. Accordingly, they default to being motivated largely by their own emotions, sporadic attention spans, and perceptions of conventional wisdom. As noted above, they are greatly influenced by news media that have a limited incentive to warn them of the attendant risks. Thus, it may not be an overstatement to suggest that most investors have only the foggiest notion of what their holdings are actually and intrinsically worth. They simply don’t know how to compare the level of prices to value. To be sure, investors individually may have a visceral feeling that bubble prices are too good to be true/sustainable, but such subliminal inklings rarely surface from the subconscious.

Further amplifying price movements is the tendency of investors to herd together. Evidence of the immense power of social pressure on individual judgment abounds. Most of us have learned that when a large group of people is unanimous in its judgment on the question of a confirmable simple fact, the group is almost certainly right. Herding militates against the theory of omniscient markets, however. If the millions of people who invest were truly independent of one another, any faulty thinking would tend to average out and would have no effect on prices. As Chart 1 confirms, however, booms and busts are a feature rather than an anomaly.

The power of sellers to stem the speculative tide is weak at best. Short-sellers tend to be loath to snarl with a Memestonk revolution. Moreover, there’s the growing hoard of index funds and ETFs (exchange traded funds), which are price and value agnostic. As fledgling investors continue their relentless buy, it has proven difficult for “smart money” to profit by betting against bubbles. The psychological contagion promotes a powerful mindset that justifies the price increases, so that participation in the bubble, during a period of suspended skepticism, might be seen as almost rational. These are additional practical and psychological factors that explain why bubbles form, obliterating the rational functioning of markets, then levitating to such logic-defying extremes that gravity itself is called into question.

It is Shiller’s contention that the mathematical theory behind the spread of infectious diseases can be used to better understand the transmission of attitudes, along with the nature of the feedback mechanism supporting speculative bubbles. When one uses the simplest of models, the initial exponential spread of the speculative fever is eventually offset by saturation and/or disaffection.

Once the psychology becomes endemic, history reveals that the ascent in prices often peaks. The retreat of rosy predictions as the market mania pauses—exhibiting a hump-shaped pattern common to epidemics—may be evidence of a natural vaccine and has historically marked the inflection (not infection) point. A viral analogy may be limited, however, for unlike COVID-19 and its multiple mutations, the speculative epidemic is likely to end abruptly.