On December 5, 1996, then Fed Chairman Alan Greenspan gave a now famous speech in which he claimed that asset markets had reached a level of irrational exuberance. In effect, Dr. Greenspan pointed to equity fundamentals that did not reflect the valuations of the time. While he was surely correct about the rising stock prices, it took another three plus years and a near 500% increase in the Nasdaq until the peak was reached and the Dot Com “bubble” burst in 2000. These days, the financial media seems obsessed with bubbles and everything that goes up in value is immediately deemed to be in a bubble. While this may be good news reporting, it may not be good for your portfolio if it influences your emotions to a level of “irrational” fear.
So how do you know what is a financial bubble and what is healthy valuation growth? Clearly, this post will not be able to fully examine this issue but let me point out that the current search for bubbles in the general public usually means that there is no bubble in the underlying asset. Why? Think about what it takes to burst a bubble as shown below.
When an asset rises in price faster than the fundamentals would suggest, the speed of the gains will accelerate reflecting euphoria and “irrational” exuberance. However, while a market might become a bubble due to unrealistic valuation, we may see a large bubble become larger without bursting as the NASDAQ displayed from 1996 to 2000.
In every historical instance that I have studied, eventually the euphoria seen has maximized and exhausted every potential buyer’s purchasing power of a particular asset after which there is simply no more demand to further increase price. At that point, the parabolic rise plateaus and then goes into a nose dive as stretched holders of the assets create an avalanche of selling while no new/few buyers can be found. Take a look at the NASDAQ chart above and you will see the exact same pattern.
As for today, I can assure you that many asset markets are fundamentally overvalued but the mere fact that public news channels are calling for bubbles everywhere is proof that many potential buyers haven’t bought at this point. Therefore, do not confuse a bubble with a rising or overvalued market. Unfortunately, in order to get these calls right, you have to be the small minority that does not own an asset at its high and buys it when nobody wants it at the lows. In other words, successful investing in volatile markets is for lonely wolves rather than sheep following the herd. Ahh-wooooooo, I mean Caveat emptor!