On a recent rereading of John Kenneth Galbraith’s “A Short History of Financial Euphoria”, he outlines common characteristics from past financial bubbles including the Tulip mania of 1637, the South Seas bubble of 1720, the various booms and busts of 19th century America, the market crash of 1929, and the October 1987 market crash. While the financial instruments vary, the behavior of investors has many elements in common. Bubbles in financial markets have several characteristics in common.
One of the elements Galbraith cites in the financial bubbles he analyzes is the introduction of new financial instruments. Such new instruments offer the “investment opportunity rich in imagined prospects…” (p51) Added to these new instruments is the element of leverage. Leverage allows investors to capture more profit than is normally possible. However, leverage also introduces fragility into the financial system when the value of investments start to fall and leverage needs to be unwound. The unwinding of leverage leads to additional sales and additional losses. The collapse of bubbles has an “inevitable and depressive aftereffect.” (p67) Such a depressive aftereffect is manifested in weakened consumer goods demand, shaken business confidence, a fall in business investment, and a rise in business failures. The bursting of bubbles has a “substantial and ultimately devastating economic effect.” (p89)
Another critical element in the development of bubbles is psychological. “Individuals were dangerously captured by belief in their own financial acumen and intelligence and conveyed this error to others.” (p51) In this aspect, bubbles not only develop from financial innovation but especially because of psychological behaviors and characteristics.
“What is not discussed in bubbles is the speculation itself or the aberrant optimism that lay behind it. Nothing is more remarkable than this: in the aftermath of speculation, the reality will be all but ignored.” (p22)
Galbraith lists the characteristics…
- There is an “extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten… Past experience is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.” (p13)
- “Individuals and institutions are captured by the wonderous satisfaction from accruing wealth.” (p106)
- “The associated illusion of insight is protected by the oft-noted public impression that intelligence marches in close step with money.” (p106) “There is a specious association of money and intelligence.” (p13) Galbraith adds, “The rediscovered wonders of leverage and the parade of publicly celebrated genius. Optimism built on optimism to drive up prices.” (p71)
- “Out of that belief, thus instilled, then comes action—the bidding up of values, whether in land, securities, or art.” (p106)
- “The upward movement confirms commitment to personal and group wisdom” (p106) Galbraith adds, “The sight of some becoming so effortlessly affluent brought the rush to participate that further powered the upward thrust” in prices. (p49)
- The upward momentum continues until “the moment of mass disillusion and the crash. “ (p106) This is “always accompanied by a desperate and largely unsuccessful effort to get out.” What ends the delusion is the sudden recognition that economic fundamentals still matter. That values in financial assets must come back to earth and reflect reality.
It is critical to understand these psychological factors that drive individuals and groups to participate in the shared delusion. These same conditions can be seen in the market in 2020-2021. In today’s age of Quantitative Easing, I would submit based on the above characteristics there are in actuality four bubbles in today’s economy, not one…
These four bubbles include…
- Equity markets which have exceeded valuations and PE levels of 2000 and 1929.
- Bond markets where QE has driven yields to historically low levels and inflated bond prices.
- SPACs, or Special Purpose Acquisition Company, which are taking companies public with little disclosure or transparency as to their earnings or fundamentals.
- Residential real estate with hedge funds and institutional investors buying up homes, and due to limited inventory driving up prices.
Galbraith points out the 1929 market bubble developed in part because, “The justifying mood was the political, social, and economic order that was associated with the benign Republican administration…” (p71) In 1929 it was Calvin Coolidge, Andrew Mellon, and Herbert Hoover… in more recent years it was Donald Trump, economic advisor Larry Kudlow, and Fed Chairman Jay Powell.
Galbraith points out that in 1929 the creation of new investment vehicles added to the increase in prices. Similar to the “joint stock company” of the 1720s, the “closed-end investment trusts and holding companies” of 1929 contributed to increasing stock prices; today we see “new investment vehicles” in SPACs, crypto and ETFs of today. “There was the requisite new financial instrument that was thought to be of stunning novelty…” (p95)
Galbraith pointed out that as prices go up in 1929, financial media and pundits continue to “assure all listeners that what was happening was well within the norms of contemporary and successful capitalism.” (p79) Today we hear from politicians, economists, and corporate executives the same mantra.
So how does a bubble end? Can market prices continue at “a new higher plateau”, as was argued in 1928-1929?
“I don’t think we’re at bubble levels yet, but there are certainly some red flags that would indicate folks are all-in on stocks and risk,” said Michael Arone, chief investment strategist for the U.S. SPDR exchange-traded fund business at State Street Global Advisors. “You need that euphoric moment for the bull market to top.” (2)
In an interview in early 2021 Jerome Powell, chairman of the US Federal Reserve, stated he didn’t see a bubble forming in markets and would not know how to recognize one. His view changed in the most recent press conference following the Fed rate decision in April, Powell said, “Parts of the markets “are a bit frothy, and that’s a fact.” (1)
“At more than 30 times reported earnings, the S&P 500 trades at a multiple that exceeds the highs during the dot-com era.”
John Authers of Bloomberg points out “through the excitement over meme stocks to the new celebrity status of Tesla Inc.’s Elon Musk, who will even host “Saturday Night Live” this week, there are plenty of signs of excess… the kind of money pouring into leveraged long exchange-traded funds (which offer you a one-stop shop for leveraged losses if the market goes down) suggests that speculation is reaching a final, dangerous stage.” (3)
Leverage has become an issue markets are acutely aware of with the failure of Greensill in Europe and and the blowup of Archegos Capital. Archegos was operating with 700% leverage across several large investment banks. Because Archegos was categorized as a family office its leverage was not publicly disclosed. Another disturbing feature of the episode is that the various investment banks were not aware of the leverage being used by Archegos at the other firms; if known, this would have raised additional red flags as to the risk they were exposing themselves too. After the close call of having to liquidate Archegos’ holdings due to a margin call, banks have started to tighten margin requirements… changes “point to greater pressure on clients to reveal their biggest wagers, stricter margin limits on those positions, more frequent collateral adjustments and more rigorous audits.” (5)
On May 6, 2021, the Federal Reserve released its semiannual Financial Stability Report. The report warned, “Rising asset prices in the stock market and elsewhere are posing increasing threats to the financial system.” (6)
“Vulnerabilities associated with elevated risk appetite are rising. Valuations across a range of asset classes have continued to rise from levels that were already elevated late last year,” Fed Governor Lael Brainard said. “The combination of stretched valuations with very high levels of corporate indebtedness bear watching because of the potential to amplify the effects of a re-pricing event.” The report cited specifically the Archegos event and vulnerabilities it exposed.
Awareness of “froth” is growing outside the US as well. In an interview with Chinese banking regulator Guo Shuqing on March 2, 2021, Shuqing stated that Chinese authorities were worried about bubbles in US and European markets, and well as in Chinese credit markets. He said, “From a banking and insurance industry’s perspective, the first step is to reduce the high leverage within the financial system.” With the interconnectedness of global markets this tightening could affect US markets as well as Chinese ones. (3)
So, what is an investor supposed to do? Work with an advisor to develop strategies designed to reduce and manage risk over the long term. Having a process in place to be aware of risks and manage risks in advance can help investors better deal with the “wall of worry”.
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A Short History of Financial Euphoria, John Kenneth Galbraith