BACK TO THE BOUTIQUE INVESTOR BLOG Financial Bubbles: A Brief History of Dizzying Ascents and Sudden Collapses Kevin T. Cooper, CFA VICE PRESIDENT | HEAD OF INVESTMENT RESEARCH In the financial world, a bubble is a period when the price of an asset—typically stocks, bonds or real estate—irrationally exceeds the asset’s intrinsic value. While this kind of irrationality can last for extended periods, it is considered a bubble only if it bursts and prices plummet as sellers frantically try to get out. The terms “financial bubble,” “asset bubble,” “economic bubble,” “market bubble” and “speculative bubble” are used interchangeably and often shortened to simply “bubble.” “Crisis” and “mania” are sometimes used as well. The Recession Connection An important characteristic of bubbles is that they frequently are followed by economic recessions, even if the bubbles do not necessarily cause the recessions. A recent study of bubbles in 17 nations spanning North America, Europe and Japan1 reveals that since World War II alone, there have been 88 recessions, of which 62 (i.e., 70%) were preceded by a bubble in equities, housing or both. 1 Jordà, Òscar, Moritz Schularick and Alan M. Taylor, “Leveraged Bubbles,” NBER Working Paper No. 21486, August 2015. Note: Recessions are a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in gross domestic product (GDP) in two successive quarters. History’s Most Infamous Bubbles There have been no fewer than 80 economic crises globally since the first century, including 25 in the twentieth century and 26 already in the twenty-first. Of the 80, moreover, 27—or one-third—took place in the U.S. either exclusively or as part of a wider phenomenon. The following are some of the most notable bubbles of all time: Tulip Mania (1634–1637) Tulip Mania was one of the earliest recorded asset bubbles. In the sixteenth century, Westerners brought the tulip plant from the Ottoman Empire to Europe, where its then-rarity and exotic beauty attracted speculators from a wide cross-section of Dutch society in the 1630s. The price of a tulip bulb reportedly rocketed twenty-fold between November 1636 and February 1637, only to plunge 99% in three months. Fortunes were lost and the Dutch economy sank into a mild depression. South Sea bubble (1720) This was one of the first stock bubbles and the origin of the term “bubble”. It centered on the South Sea Company, to which the British government had promised a monopoly on trade with Spain’s South American colonies in exchange for the assumption of Britain’s massive war debts. South Sea shares soared more than 800% in 1720 on false rumors of the company’s huge success. Thousands of overextended investors across British society were ruined when the share price collapsed, causing a severe economic crisis. Railway Mania (1840s) Railway Mania was an economic and speculative bubble resulting from the introduction of modern railroads to Britain. Like the Internet bubble 150 years later, it was marked by investors’ insatiable appetite for a disruptive technology. Railroad stocks soared to dizzying heights and massive overbuilding took place: At one point, the money put into railway construction was more than double British military spending. When the bubble popped, many railroad companies went under, shareholders were devastated and outstanding debts were enormous. Wall Street crash of 1929 Even today, nearly a century after it happened, the crash of 1929 remains the quintessential cautionary tale of a financial bubble. Many of the fundamental bubble characteristics that we describe later—excessive use of leverage to buy stocks, herd-like behavior, overconfidence and the mass popularity of speculation—were present and unstoppable. Even though the “official” crash occurred on October 29, 1929 (the infamous “Black Tuesday”), prices continued to drop and finally bottomed three years later. The repercussions were widespread and devastating, with suicides, sky-high unemployment, millions thrown into poverty, and thousands of bank failures in the Great Depression. Japanese economic bubble (1980s) In response to a mid-1980s recession, the Japanese government undertook aggressive fiscal and monetary stimulus to turn the nation’s economy around. The plan worked too well: The subsequent economic boom resulted in Japanese stock prices and urban land values tripling between 1985 and the bubble’s peak in 1989. Japan’s economy deteriorated after that, as stocks and real estate slid and led the country into an agonizing period of deflation and stagnation (“stagflation”)— known as the lost decades—that lasted more than 20 years. Stock market crash of 1987 The bubble in U.S. stocks that inflated in 1986 burst wide open on October 19, 1987, when the Dow Jones Industrial Average fell 22.6%—still the biggest single-day percentage loss in U.S. history. “Black Monday,” as it is known, was the culmination of euphoric speculation fueled by hostile takeovers, insider trading, a flood of initial public offerings (IPOs) and newly popular leveraged buyouts funded by junk bonds. But the nail in the coffin that day was portfolio insurance, an automated hedging strategy in which big institutions sold stock-index futures to soften the blow of falling prices. Portfolio insurance programs kicked in as the sell-off raged—resulting in yet more selling and exacerbating the decline. Unlike most bubbles, Black Monday did not feed a recession, as stocks recovered within weeks and resumed their upward climb. Internet/dot.com bubble (late 1990s) The internet bubble—also known as the dot.com bubble or the tech bubble—was a classic case of mass market hysteria. The excitement of the then-nascent internet lured investors into the stocks of web-related names like Webvan, Pets.com, eToys.com and many others that had not even turned a profit yet. Valuations went through the roof amid declarations of a new status quo in which earnings did not matter. The tech-dominated NASDAQ Composite Index spiked to a new high in March 2000 and then dropped like a rock before bottoming in October 2002. As if on cue, a recession followed the peak. U.S. housing bubble (2007–2009) The housing bubble was painful proof that investors have short memories. Even as the economy and financial markets emerged from the wreckage of the internet bubble, a new home-buying mania took shape. In retrospect, warning signs abounded: unsustainable consumer debt, rampant mortgage fraud, mounting defaults, willful ignorance of credit deterioration in mortgage-related securities— yet most investors looked the other way. The resulting global financial crisis was the worst economic contraction since the Great Depression, and the world continues to feel its effects today.