Part 3 of a 5-part Series: What Have Past Inflation Crises Taught Us About Investing?
By James Pearcy-Caldwell, Aisa Co-Founder and Compliance Officer, and Chris Lean, Chief Investment Officer
A “bubble,” is where the price for something is no longer based on intrinsic worth nor fundamental valuations. This leads to speculation, which drives prices higher, exceeding any rational valuation normally used. Consequently, due to it not being based on intrinsic value, the bubble is driven by speculative demand and grows larger.
How do bubbles begin?
Bubbles often start with a new idea, such as recently, Artificial Intelligence (AI) and “all the things it can do for us”. Prices may rise slowly until it gains momentum from more and more participants. These are more people thinking they need to be in on this one, which leads to boom phase.
Then, the asset in question, AI, attracts widespread media coverage. An increasing number of people see this and talk about the future. They begin to fear missing out, spurring further speculation, and more investors risking their money.
As euphoria sets in, a bit like the recent cryptocurrencies examples, people who have no idea about investing, and even some who do, throw caution to the wind. They are encouraged by each other, hearing stories of rapid wealth and easy money. Valuations reach extreme levels as new valuation measures and metrics are touted linked to the theory it will be “different this time”.
Bubbles burst
It is at this point that clever investors recognise the warning signs that, not only is there a bubble, but it is likely to burst soon. This is the time to sell and take any profits. Even though it is impossible to time this perfectly, it only takes a relatively minor event to prick a bubble.
If the assets have not been sold and investors hold on, they start to see the asset price reduce, sometimes constantly, sometimes rapidly. At this point asset prices have reversed and can go down as rapidly as they went up.
Investors, faced with plunging values of their holdings, now want to liquidate at any price before it gets worse in their mind. This is the panic stage of the bubble and anyone who invested in the later stages of the bubble stands to lose a lot of their investment money. If they have been operating on borrowing or margin calls, they may lose all their money.
Types of economic bubbles
- Stock market bubbles involve equities—shares of stocks that rise rapidly in price, often out of proportion to their companies’ fundamental value (their earnings, assets, etc.). These bubbles can include the overall stock market, exchange-traded funds (ETFs), or equities in a particular field or market sector.
- Asset market bubbles involve industries or sections of the economy outside of equities. Cryptocurrencies and real estate are classic examples.
- Commodity bubbles involve an increase in the price of traded commodities.
- Credit bubbles involve a sudden surge in consumer or business loans, debt instruments, and other forms of credit linked to slack lending criteria or low rates. Specific examples of assets include corporate bonds, government bonds, or mortgages.
Why are bubbles relevant in this discussion? There has been a series of bubbles over the last 10 years based on the low interest rates that have been available. Combined with governments’ printing of money, this has led to large-scale asset price increases (where the rich get richer). It happens in many areas linked to lending or speculation, or simply the availability of money.
When the norm is not the norm
2022 and 2023 have started to see some of these bubbles burst, whilst creating others due to further new technology or plans for net zero of huge government lending programmes. All of these have destabilised the normal operation of markets or they have amplified returns, such as those seen in real estate over the last 15 years.
With the return to higher interest rates, sensible investors are now planning for the next cycle. It is also fair to write that a long period has passed, during which many people under the age of 35 have never experienced anything other than what has been happening. Therefore, they see it as the norm. However, this also makes them unprepared for a recession or high interest rates, or asset price deflation, nor stagflation.
Market reaction in previous stagflation / recessionary times
These have previous market reactions:
Barber Boom – 1972-74 (1973-75 recession)
- Best performers: Commodities (food, raw agricultural materials, metals) saw a sharp increase at the initial crisis point, followed by a big drop in the 1975 recession.
Lawson Boom – 1985-88 (cause of recession of 1990-92):
- House price crash of 20-30% between 1988-93. 40% of Londoners who bought homes in the 80s had negative equity at this point, caused by rising inflation. This triggered 15% interest rates (similar to the current situation).
Labour markets decline leading to unemployment.
Banks enter financial difficulties as house price drops lead to many banks needing to boost their capital ratios by reducing loan portfolios at the same time, lowering value of loans in secondary market.
Forex trade profits increase – Housing market decline leads to a cut in interest rates to encourage spending. This devalues the pound, leading to FX traders’ short pound.
UK Markets 1990-1994
Self Storage Share Prices Around 2008
- https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1981/commodity-prices-in-the1970s.pdf
- https://www.cityindex.com/en-uk/news-and-analysis/how-would-a-housing-market-crash-impact-financialmarkets/
- https://www.onlondon.co.uk/richard-brown-what-type-of-recession-is-heading-londons-way-this-time/
- https://www.hl.co.uk/news/articles/2-fund-ideas-to-survive-a-recession
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