We are the dot-com generation. As such, we lived through a historic boom and bust bubble cycle that was significantly injurious to the economy. Every American was affected in some way by this event. A key characteristic of the price run-up was that so few were willing to admit there was a problem, and even fewer still were willing to act on that belief.
Now that we’re on the other side of the burst, we may feel as though we’re experts on bubbles. Although we hear talk about bubbles all the time, the truth is that they tend to be rare events. Nevertheless, we look at current market trends and wonder whether it is a bubble or just a strong bull market. What is the difference?
According to one standardized definition (Wikipedia), a speculative bubble is distinguished by “trade in high volumes at prices that are considerably at variance with intrinsic values and could also be described as a situation which asset prices appear to be based on implausible or inconsistent views about the future.” In other words, it’s a mania.
A common historic example is the Dutch tulip price bubble of the mid-1600s when tulip bulbs sold for more than 10 times the income of a skilled craftsman. The only explanation of such a scenario is psychological. In his book “Extraordinary Popular Delusions and the Madness of Crowds,” Charles Mackay explains how a crowd will behave irrationally from time to time. Another popular theory about manias and bubbles is the so-called “greater fool theory” that describes market participants beliving they can speculate on an asset, and no matter how overpriced it gets, they can resell it to some other speculator. This explanation certainly sounds familiar to those caught up in the housing bubble that peaked around 2006.
Riding the bull
We now need to differentiate bubbles from bull markets, which is a trend of confidence and increasing asset prices over a long period of time. A secular trend can last anywhere from five to 20 years. The two most powerful secular stock market trends in the second half of the 20th century lasted 17 years (1949-1966) and 18 years (1982-2000). While a bull market can end with a bubble, most of the time investors were optimistic about the future but did not view the future implausibly until the end.
The main difference between a bull and a bubble is the speculative component. One example is a company called Norris Communications. This was a bulletin board company that changed its name to e.Digital in 1999 when it traded that January at $0.06 per share. By Dec. 31, 1999, it was trading at $2.91. Three weeks later it was at $24.50. It quickly collapsed and resumed its former low price at $0.10 .
Perhaps the key component is the implausibility factor. In the British railway mania of the 1840s, total railway revenues in Britain in 1845 were £6 million. The expectation was for £60 million by 1852 while the actual revenues came in at £15 million. While tenfold increases are the expectation for new technologies or industries, by the 1840s the rails were no longer considered a new technology or industry. There had been a smaller rail bubble in the 1830s in Britain where revenues did increase tenfold. But to continue at that rate invoked the implausibility factor.
A bull and a bubble also can be differentiated by obvious market sentiment. While a bull market climbs a wall of worry — or caution — the characteristic sentiment of a bubble is a laissez-faire attitude and the belief that “this time is different.”
After the financial crisis bottomed in 2009, media commentators would interview many guests and ask if they thought there would be a double-dip recession. The question was asked continuously while the market kept rising. In a bubble, nobody talks about recessions or is even worried about the possibility of a decline. In fact, the key psychological component is denial that prices ever could decline to past levels. Applying this analysis to today’s rising stock market, it would suggest that this is a true bull market, as caution and worry have certainly accompanied the higher prices.