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 The market’s major innovation of the last decade or two is the return of the bubble. While banks, brokers and others were hard at work developing new ways to make money in the investment markets, the market itself introduced the most powerful, and frustrating, innovation of all: short, steep boom-and-bust cycles better known as bubbles. Some of the bubbles we’ve seen include tech stocks (and Nasdaq-listed stocks in general) in 2000, home prices in 2005-2008 (in the U.S., the U.K. and Spain, among other places) and Chinese A-shares at various times in the last decade.
Few if any of the investment ideas of the last 20 years provided half as many gains as the bubbles took away. After all, the S&P 500 opened 2010 lower than where it closed 2000, or for that matter, 1997. True, some people made money through the decade of the 2000s, but they were few in number; the idea that one could participate in overall economic growth by owning stocks just didn’t work.
Bubbles weren’t new in the 21st century—they’ve been around since at least the 17th century, when there were tulip bulbs in Holland. But they have returned with a vengeance.
One of the most unfortunate things about bubbles is that they don’t usually come with large warning signs reading “Entering the Bubble Zone.” Rather, they seem to creep up slowly, giving people time to develop arguments about what might be happening. Bubbles can be big and explosive or small and seemingly unchanging; they can switch from modest price increases that slightly stretch valuations to booms and busts that threaten economies. They can make the transition in a year or a week.
A defense against bubbles would be welcome. Currently most regulators—who should be protecting us from such things—argue that in the middle of a bubble, one can’t tell that you’re in a bubble, and further efforts to control the bubble would slow the economy or collapse stock prices. Neither regulators nor investors are quite so powerless. Forecasting with 100 percent accuracy may not be possible, but that hasn’t stopped people from making and acting on forecasts of bubbles or other market events. The worrisome thing about trying to control bubbles is that policies to control a bubble, if applied when there is no bubble, might indeed—as those regulators suggest—slow the economy or end a bull market. While many of the myriad books and articles dissecting the financial crisis offer estimates of the costs of controlling bubbles or tools to predict bubbles, the big question is, how do we decide when to attack the bubble? A little crude analysis may help.
What we have, essentially, is a decision problem. If we’re in a bubble, steps such as restricting trading, increasing margin requirements, or raising interest rates and trading costs can rein in the boom before prices reach extremes. But if these actions are taken and there is no bubble, regulators will have killed off a bull market for no reason—not a popular action. On the other hand, if regulators assume there is no danger and the bubble bursts, the resulting bear market and recession could be nasty. A diagram with some damage figures can sort this out (see Figure 1).
The markets are either in a bubble or not. The two columns on the right represent the actual market condition: Bubble or No Bubble. The two rows represent the regulators’ point of view: They either believe there is, or is not, a bubble. The numbers in the four boxes represent the damages caused by each case.
Starting in the upper left number box, if there is a bubble and the regulators guess correctly, the damage is 600; if the regulators are wrong—they don’t see the bubble but it is there—the damages are 1,000. Now suppose that there is no bubble (extreme right-hand column). If regulators are correct, the damage is zero (bottom right), while if the regulators invoke policies to control a bubble that isn’t there, the policy of tight money or trading restrictions still leads to damages of 300. (All these figures are just for illustration and are not based on real data or estimates.)
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