Is another financial bubble imminent?

Posted by on Mar 27, 2016 in Economics
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Extremely low interest rates and record high stock markets (now returning after a sharp correction in the second half of 2015 and at the beginning of this year) are bringing back a cyclically returning question: Is another financial bubble imminent? The simple answer is, of course, that we have no idea. There are so many factors at play that the exact timing of the next bubble is simply unknowable. As ever, a bit of history and analysis is helpful.

Hyman Minsky noted that speculative euphoria develops as cash flows rise beyond what is needed to pay off debt and that an increase in speculative and Ponzi schemes brings financial instability. This insight already implies some behaviourally and psychologically driven actions by market participants, particularly when leading up to or in times of crisis.

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Investor Phases and Valuations. (Source: Dr. Jean-Paul Rodrigue Dept. of Global Studies & Geography Hofstra University)

A well-studied example of this can be observed in an environment of rising house prices. As prices of real estate assets rally, house-owners start to feel wealthier, which leads them to consume, borrow and risk more even though nothing fundamental has changed and they haven’t yet realised any potential profits. The cause of this behavioural change is purely psychological. Your neighbours, who are in a very similar position, will start to spend more so why shouldn’t you? As soon as this trend gains momentum, another trend starts to show that is also a salient human trait. As Ira Epstein and David Garfield noted in their book “The Psychology of Investing”, people tend to extrapolate from the past to the future, which is a simple economic but a complex psychological issue: The recency and impact of financial events – in that order – are what subconsciously drives peoples’ investment decisions. As a result, market participants forget past episodes quickly and form their ‘experience’ mostly from recent events, thus leaving them to extrapolating from the last half decade or so – at least without the help of more formal tools for better judgement. This human rationale is often used to explain, for example, why there have been 4 hot IPO markets within the last 5 decades.

What follows this phase of euphoria in any bubble is a likewise psychological phenomenon. Some early warning signs begin to show in what is often called the ‘profit taking’ period. In this period, some investors see that markets are acting irrationally and that the upward trend in asset prices can’t continue. Such an early signal is often seen in banks’ actions as their analysts closely monitor the market and often decide to pull out of unsustainable bubbles ahead of time. In 2007, ahead of the great financial crisis, some banks and investors started to shed their exposure to U.S. subprime mortgages. This was several months before the great crash that brought down Lehmann Brothers and shows that rationality returns to some investor’s psyche before it is to late but only when they see that they are faced with existential risk.

Finally, the ‘panic stage’ or ‘crash’ materialises as a major share of market participants take emotional decisions to shed assets like running towards the exit in a burning building. The result is, of course, that supply overwhelms demand and asset prices slide sharply. Such behaviour is largely irrational as it is a herd mentality that leads several investors to just follow what others seem to be doing or deem necessary. Further, recent events have shown a new dimension to how the world experiences a crisis. Contagion, resulting from increased interconnectivity, means that a financial crisis in one part of world quickly has a depressing effect on many other markets. Here too, psychology plays an important role. Watching the news and learning about a major crisis in another country will depress your personal view for the outlook of your own country even without a fundamental economic link between the two. On top of that comes the fact that multinationals are indeed more than ever before exposed to foreign markets, taking most financial disruptions immediately to a global level.

What the unprecedented level of connectivity and resulting synchronisation between markets, servers and brains has brought is a more efficient and less volatile financial system at the cost of a massive systematic risk faced when things do go wrong – leaving no geography, industry or individual unaffected. Thus the financial system is shifting risk out of our models and into the ‘fat-tails’ where it is unaccounted for, invisible and by the rules of our psychology easy to forget.

The answer to this post’s question is therefore – more than at the onset of any previous bubble – we don’t know.

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