Stock market bubbles – lessons from history

Financial manias and bubbles are features of financial markets which are not inevitable, but probably happen more frequently than they should.

We’re currently seeing both high valuations of some shares on Wall Street and large numbers of new investors into the stock market. From this, is it worth stepping back and asking if a bubble is forming in some shares? If so, what are the patterns we should look for?

Speculating – a lesson from the South Sea Bubble

“I can calculate the motion of the heavenly bodies, but not the madness of people.” – Sir Isaac Newton on losing a substantial sum in the infamous South Sea Bubble of 1720.

If somebody as wise as Sir Isaac Newton can be drawn into a speculation, the rest of us can be too.

To lots of new investors, the glamour and excitement of share price movements in America, along with social media hype, could make a volatile market seem like an exciting novelty.

As it stands, lots of those who joined in the frenzy of buying certain speculative American stocks in recent weeks based on social media tips, could’ve lost money.

This is a lesson about the risk of speculation, the importance of investing for the long term, not the short term, and holding a diversified portfolio.

Economists Hyman Minsky and Kindleberger wrote that markets go through cycles. There is a positive development – “an exogenous shock” – which interests investors. This is followed by excessive credit expansion when banks become too optimistic about the state of the economy. This, in turn, can lead to a speculative mania which suddenly goes into reverse. Having made substantial profits, investors sell out after perhaps being spooked by a minor crisis, like a product failing or a fraud being exposed.

If we apply this to the state of stock markets now, a similar pattern emerges, but only in certain investments. Technological advances, such as electric cars and online retailing, are delivering genuine opportunities. But the coronavirus pandemic has encouraged central banks and governments to pump truly enormous sums into the economy. This is the credit expansion phase.

Thomas Levinson, an American academic, has just published a new history of the South Sea Bubble called Money for Nothing. The South Sea Company had a monopoly on trade with South America, but it evolved into a scheme to swap the national debt for shares.

Thousands of people invested before it collapsed. Levinson notes that some early investors, sold before the peak, at a profit. They did so “not because of any sophisticated quantitative argument”, but because “what had been a dull and long-term investment had changed into something else, a speculation, a gamble.”

How to potentially spot a bubble

The following trends can normally be a sign of a bubble forming:

• Stock prices suddenly forming part of everyday conversation, far from the City or Wall Street
• Politicians and celebrities tipping or promoting shares
• Corrupt or irresponsible media activity, including social media. For example, during the South Sea Bubble, the writer Daniel Defoe turned from being a critic to being hired to publicise it
• Newly listed companies going to a massive premium (being worth more than they maybe should be) soon after trading starts
• The appearance of companies with unusual names which are either simply raising cash for unclear reasons, or are making exaggerated claims about how new technology is transforming their business
• High profile frauds
• Insiders, such as company founders, selling out or retiring

When bubbles pop it affects pretty much everyone invested. While investors might not be able to escape the bursting of the bubble completely, there are ways to limit the impact it can have on your investments.

How to help bubble-proof your investments

The stock market is not a casino. Gambling is a zero-sum game. By contrast, in an investment both sides of the transaction should, in theory, benefit. The organisation selling shares is raising capital, and the investor is putting in money to achieve a return over time, either through capital growth or dividends, or both.

Remember though, all investments can fall as well as rise in value so you could make a loss. This article isn’t personal advice, if you’re not sure what’s right for you, seek advice. Past performance isn’t a guide to the future.

Instead of indulging in short-term speculation, the better approach is to take a longer term view and make sure your portfolio is well diversified. This could perhaps be through investing in funds or investment trusts. By all means invest in some individual shares if you have the risk appetite and an understanding of the company and its value. Remember though, it is always hard for amateurs to beat professionals in any walk of life, as Sir Isaac Newton discovered.

George Trefgarne is CEO of Boscobel & Partners, a political consultancy. Hargreaves Lansdown may not share the views of the author.

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