Periods of inflated asset prices have always been a feature of markets. But it was not until December 1720 that Jonathan Swift, the author of Gulliver’s Travels, coined the term ‘bubble’ in a poem dissecting the greed and delusion surrounding the South Sea Company. The metaphor stuck because it was apt: financial bubbles float free of market forces until they burst, and the consequences are messy.
If bubbles are periods when assets become overvalued, it may help to consider what gives an asset value. Typically, assets are valued for their rarity or their usefulness. Gavekal Research distinguishes between ‘jewels’ (rare assets) and ‘tools’ (useful ones).1 Bubbles emerge when investors either misjudge the scarcity of an asset, such as tulips or gold, or overestimate the future cash flows from new productivity advances, such as the railway or the internet. Some assets, such as property, can be both rare and useful.
The modern definition of financial bubbles is hotly debated. Jeremy Grantham of asset manager GMO takes the scientific approach, asserting “bubbles are definable events when the price action is two standard deviations from a long-term trend”.2 Robert J Shiller, renowned for challenging the notion of rational markets, calls a bubble “an unsustainable increase in prices brought on by investors’ buying behaviour rather than by genuine, fundamental information about value.”3
However bubbles are defined, the problem has always been knowing when you are in one. In seeking to identify them, it helps that bubbles – like the human behaviours which drive them – tend to follow a set pattern, with several distinct phases. We think of those as: national pastime, new paradigm, feedback loops and frauds and scapegoating.