4.3.2 Bubbles

Periodically, periods of manic buying affects financial markets – particularly share markets.

There have been many examples of share prices ballooning skywards on upbeat speculation about the prospects for certain companies, only to plummet on discovery that these prospects are more a mirage than a reality.

In these circumstances, the share price movement is like an expanding bubble that, at some point, will inevitably burst.

Watch the following video, in which a number of specialists in personal and corporate finance discuss what is meant by the term ‘bubble’.

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[Sound of bubbles]

NARRATOR

So what exactly is the definition of a bubble?

DAVID LLEWELLYN (Loughborough University)

People buy simply because they believe that everybody else is going to buy. You get what is called a bandwagon effect and from time to time you then get a situation where prices go far too high and that is really what we call a bubble.

NARRATOR

Bubbles are characterized by volatility with shares swinging from wildly over to wildly under priced often in a matter of minutes.

MARIANA MAZZUCATO (The Open University)

Robert Shiller from Yale University talked about bubbles arising from irrational exuberance and what he’s done to actually measure bubbles is he’s defined excess volatility to mean the degree to which stock prices are much more volatile than the underline fundamentals, which in theory they are tracking.

NARRATOR

There are also more specific types of bubble.

JAMES MONTIER (Author, Behavioural Investing)

The first form of bubbles are what we call bubbles of belief or fads. These are bubbles that are really driven by hype.

NARRATOR

The tulip bubble in seventeenth century Holland was a good example of this. Flowers were traded for up the ten times the annual wage of a skilled craftsman or in exchange for a six bedroomed house. One bulb sold for six thousand Dutch florins at a time when a ton of butter was just one hundred. In 1637 prices collapsed meaning they were no more valuable than onions. Britain’s South Sea bubble of 1720 was another bubble of belief. Set up to trade in South America, the South Sea companies’ promise of huge growth lead to fevered speculation.

MARTIN WOLF (Chief Economic Commentator, Financial Times)

Sir Isaac Newton who bought shares in the South Sea bubble, made an enormous amount of money, sold the shares. He was fine and then he saw it going on up and he bought again and he lost it all.

NARRATOR

After losing twenty thousand pounds he observed that he could, ‘Calculate the movement of the stars but not the madness of men’. James Montier calls the next type of bubble an intrinsic bubble.

JAMES MONTIER

These are bubble in fundamentals rather than actually bubbles in prices. So behavior of the financial sector in the last seven or eight years might be regarded as an intrinsic bubble because they geared up - so it looked like they were actually profitable but in fact it was all just leverage.

[CRASH]

NARRATOR

Another type is known as an informational bubble

JAMES MONTIER

Certain parties in the market will know things that other parties don’t and they may not transact on that information. So not all information is properly reflected in prices. They tend to be very stock specific rather than market level events.

NARRATOR

On a wider market level, the price increases in the U.K. housing from the mid 1990s until 2007 are seen by many economists as a classic bubble.

JOHN CALVERLEY (Standard Chartered Bank)

In my view the big rise in house prices in the U.K. and some other countries in the last ten years is a bubble. Some people argue that with the low interest rate environment we’ve had in the last several years, with the lack of housing supply and so on that the high prices of houses are justified. I don’t think that’s right. I think that what’s happened is we’ve seen people convinced that house prices would forever raise and they’ve been buying bigger houses and more expensive houses that they otherwise would need. And so we’ve had an excess demand created by the view that house prices would always go up. I think, for me, that justified calling it a bubble.

[Bubble sounds]

End transcript

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The origin of the term ‘bubble’ is thought to emanate from the fate of the South Sea Company. The saga of the South Sea Bubble in the eighteenth century has great similarities with other more contemporary bubbles, such as the so-called dot-com bubble in the early 2000s.

The South Sea Company was formed in 1711 and was given a monopoly to trade in Spain’s South American colonies. The overhyped prospects for this business in the New World built up a frenzy of speculation in the shares issued by the South Sea Company. This reached a head in 1719 and 1720. The company’s share price rose from £128 in January 1720 to £1000 by August, only to collapse to £150 in the subsequent month. The extent of involvement in this share price bubble, including members of the Government, and the sharp decline in the share price resulted in widespread bankruptcies and company failures. Curiously, the South Sea Company itself survived, albeit in a restructured form, and traded for another century.

Spotting bubbles is a crucial skill in investment management. If you have invested in a share whose price is rising rapidly, you need to determine whether this is because of the company’s performance or simply hype, based on unrealistic expectations about the company’s potential. If it is the latter, get out before the bubble bursts!