Another more famous instance of financial insanity and speculative fever was a period known as the Tulip bulb mania, which started in Holland in 1634–37. It seems that this mania wasn’t referred to as a bubble, perhaps because of the difficulty for the human tongue in saying “tulip bulb bubble.” Most people, wealthy and poor alike, became besotted with the idea of owning and trading tulip bulbs for financial gain. Bulbs were listed for trading like a stock on one of the earliest stock exchanges, the Amsterdam Exchange. Prices soared to the equivalent of an average person’s life savings for one rare bulb. The fad spread to England and many other countries. Even today in Holland rare species of tulip bulbs trade at lofty prices, although nothing like the ridiculous values that were common four hundred years ago. The principal attributes of these activities, whether called bubbles or not, were a degree of excessive speculation, inflated prices, and a subsequent crash along with widespread public involvement and fascination.
Many writers and historians have tried and failed to make sense of the innumerable instances of inflated values for commodities, stocks, real estate, and other speculative vehicles caused by excessive greed and speculation. Economic theory doesn’t do any better in providing explanations since bubbles don’t readily allow analysis using advanced mathematics. Modern economic theory avoids the difficulty of understanding bubbles and mania by assuming that all human participants in economic activities are rational at all times under the efficient markets hypothesis. The Canadian-born economist J.K. Galbraith, who taught at Harvard University, discussed many of the most extreme bubbles in A Short History Of Financial Euphoria. Unfortunately he, too, fails to come up with a suitable definition of the bubble phenomenon. Galbraith states that recurring episodes of collective financial insanity, fuelled by greed, are inevitable.[2] Since it’s impossible for people to detect when they are in the grips of a manic episode of excessive speculation, the only defense is to develop a healthy degree of skepticism, an attitude that comes naturally to few people. For lack of another more suitable word, and recognizing that it isn’t precise, I will refer to markets that are overvalued and in the grips of speculative fever as bubbles. The word mania could be used, having the advantage over bubble that it implies a degree of mental illness or instability that is usually associated with the phenomenon.
Jeremy Grantham, founder of the large investment firm GMO, based in Boston, Massachusetts, manages over $120 billion of investments for institutional investors such as pension plans, endowment funds, and companies. I first met him, a slender man in his seventies, in New York City after he presented at a conference in 2003. He opened his remarks by stating, “I’ve never been wrong.” The room went completely silent as two hundred investment experts and portfolio managers mulled that over. After a very long, awkward pause he continued, “I’ve been early” and the room erupted in laughter.
Grantham captured in a very succinct manner the universal difficulty of talking about bubbles and the inevitability of them bursting. Any prognosticator who calls for a crash in a bubble asset invariably looks like a fool for a period of time before eventually, perhaps, being proven right. In the interim the forecaster predicting the collapse is contradicted by higher and higher prices leading to greater and greater wealth for bubble participants who ignore the warnings. Inevitably the public (and clients if the advisor is in the investment business) develops disdain for the person making the unfortunate “early” prediction. As Grantham says in a 2014 report, “the pain will be psychological and will come from looking like an old fuddy-duddy.”[3] However, in the big picture of cycles, those who were forecasting a collapse in the U.S. housing market in 2004 and 2005 were only a year or two early. In real estate, one or two years is a short time. It takes that long sometimes to get a house ready to sell, put it on the market, and wait for the right buyer to offer the right price.
Anyway, Grantham was very early in 2003 with his predictions about a stock market crash, but eventually he was more than right when the global financial crisis hit, starting in 2006 with housing, and in 2007 with Bear Stearns and 2008 with the Lehman Brothers collapse.
Grantham describes his research into bubbles. His research showed that “all 28 major bubbles … eventually retreated all the way back to the original trend, the trend that had existed prior to each bubble, a very tough standard indeed.”[4] The definition of a bubble that GMO settled on was any event that was two standard deviations from the mean, expected to occur once every forty-four years. Grantham describes the U.S. housing bubble that exceeded 3.5 standard deviations from the mean, an event that would be expected to happen only once every five thousand years. The U.S. housing bubble started to take shape in 2000, reached one standard deviation about the trend line around 2001, exceeded two standard deviations during 2003 and peaked above three standard deviations in 2005, going to one standard deviation below the mean in 2008. All done in about eight years, a very compact and devastating bubble and bursting that will have repercussions for the U.S. and the world for decades.
“All bubbles … retreated back to their original trend.”
— Jeremy Grantham
And the cycle of a U.S. housing bubble and crash had never happened before for residential housing on a nationwide basis. Before the 2000-08 bubble, all housing market bubbles were local and there have been many. Real property or real estate, in the form of raw land or housing, provides fertile ground in which to grow a bubble. Especially in North America, where the history of widespread land ownership is only about two hundred years old, the episodes of mania that have developed from time to time are legion. After all, many of the people that moved to North America from Europe came because of the opportunity to own land, something that was difficult in their country of origin.
Shiller discusses the recent worldwide real estate bubbles: “We have no shortage of recent examples of real estate booms to consider. There were sharp home price increases after 2000 in cities in Australia, Canada, China, France, Hong Kong, Ireland, Italy, New Zealand, Norway, Russia, South Africa, Spain, the United Kingdom, and the United States.”[5] If bubbles or booms are likely to be a recurring phenomenon in the history of human financial activity, then individual homes and those who own the homes are ripe to exposure to the bubble activity. Houses will be the target of widespread speculative activity since almost everyone is interested, has a view on what the proper values are, and has a lot at stake given the size of the investment.
Shiller on the definition of a bubble, from the transcript of an NPR interview with Shiller and fellow 2013 Nobel Prize–winner Eugene Fama, hosted by David Kestenbaum.
“It’s like a mental illness.” He goes on to say: “Symptom one: Rapidly increasing prices. Symptom two: People tell each other stories that purport to justify the bubble. Symptom three: People feel envy and regret they haven’t participated. Oh, I would add one more — the news media are involved.”[6]
Canada’s house price increase since the late 1990s fits well with all four categories. Of course, there is no bubble if it doesn’t come to an end at some point, with a large decline in prices. And there is no bubble if prices don’t rise above the long-term sustainable fundamental or intrinsic value. Both of these requirements are difficult to prove in advance of the post-bubble price collapse so there is always room for debate until after the deflation period. And no one can predict when a bubble will end, making people look foolish for months and years before they are eventually proven correct. The Economist was early also in its prediction of a collapse in U.S. housing prices, but turned out to be prescient.