The minutes of the latest Federal Reserve policy meeting, released this past week, show that central bankers have been worrying that the financial markets might turn into a bubble — the term for a perilously overvalued situation that can burst without warning or mercy.
Those who want to understand whether markets are in a bubble today should study the first bubble from almost three centuries ago.
The clearest lesson from history: Worries about a bubble matter less than how the investing public reacts to those worries. By that standard, while today’s stock market is no bargain, it doesn’t resemble the classic overhyped and hyperreactive markets that experts generally agree were bubbles, such as 1999-2000, 1929 and 1720.
This takeaway comes from the most visually stunning and, in my opinion, one of the most important investing books of the past year: “The Great Mirror of Folly: Finance, Culture, and the Crash of 1720,” published in November by Yale University Press. The volume commemorates a collection of prints, poems, plays and prospectuses first published in Amsterdam 294 years ago.
With commentary by a stellar team of researchers, including Nobel Prize-winning economist Robert Shiller and finance professors William Goetzmann and Geert Rouwenhorst — all of whom teach at Yale — the book is partly a replica of dozens of spectacular early engravings and partly a series of scholarly essays about the world’s first international financial crash.
In a matter of months in 1719 and 1720, many leading stocks in France, Britain and the Netherlands went up roughly tenfold, then collapsed nearly as fast as they had soared. Many investors from all walks of life, including Isaac Newton, suffered losses that often exceeded 90%.
Some economists and historians claim that bubbles result from the madness of crowds — investors turning irrational en masse.
But it is hard to argue that investors in 1720 were entirely irrational, says Prof. Goetzmann: Nearly all the companies in the boom sought to capitalize on trade with America, and most were organized as corporations with publicly traded securities, a structure that spread risk and provided liquidity as never before.
“Investors at the time recognized that these could be transformational innovations,” Prof. Goetzmann says. And trans-Atlantic trade and corporate ownership changed the world for centuries to come.
So the people who bought into those companies weren’t wrong. They just ended up paying too much to be right — just like investors in Internet companies in 1999.
It isn’t easy to identify a similarly universal belief among investors today that the world is being swept up by an irresistible positive force. The artificially low interest rates set by central banks, while powerful, are hardly a technological breakthrough.
Another sign to watch for: In every bubble, there are always people trying to burst it by declaring that financial assets have become overvalued. At first, Prof. Goetzmann says, such skeptics earn respectful attention. But eventually, investors turn on them with anger and ridicule.
Just think of Warren Buffett, who in 1999 and early 2000 was widely derided as “a dinosaur” and “out of touch” for his refusal to buy technology stocks. When I asked him in January 2000 how he felt about that, Mr. Buffett replied calmly: “I know what will happen. I just don’t know when.” Two months later, the Internet bubble burst.
In investing, as in life, ridiculing the people who disagree with you is a fairly certain sign that you don’t have the facts on your side.
“Once people buy in, they start to discount evidence that challenges them,” Prof. Goetzmann says. “There seems to be a hinge point where investors go from thinking about quantifying economic trade-offs to a kind of binary framework where anybody who disagrees with them is demonized,” he says.
That is when a bubble becomes trouble.
“When everyone starts to use ‘bubble’ anytime prices go up, it’s probably not one,” says Jason Hsu, chief investment officer at Research Affiliates, a firm in Newport Beach, Calif., whose investment strategies are used to manage approximately $150 billion in assets. “The time to worry is when people are using all kinds of rationalizations as to why it’s not a bubble.”
None of this means, of course, that today’s stock market is cheap; by most measures, it is at least slightly overvalued. But the fact that you can’t open a newspaper, watch financial television or visit an investment website without encountering a commentator worrying about a bubble is probably encouraging.
And the fact that market pundits can declare that this is a bubble without being insulted is almost certainly a good sign.
When hearing someone call the market a bubble makes you want to call the person an idiot, that is when you should ask yourself whether in fact the idiot is you. We probably aren’t there — yet.
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