The American Civil War broke out in April 1861, shortly after Abraham Lincoln became President of the United States. At the center of the domestic unrest was slavery. 

The Civil War disrupted cotton supply to clothing mills in Britain. They needed new sources of cotton to keep the production going. And they turned to India. 


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The British mills purchased 528,000 bales of cotton from India in 1860. But the cotton-hungry mills bought 1.2 million bales from India in 1865.

The demand was expected to keep rising. People had begun referring to cotton as the “white gold.”

Demand was so strong that traders would tear apart their own pillows and mattresses to sell the cotton stuffing. The white gold had become way too valuable for pillows. The cheaper and not-so-in-demand coir fiber replaced it in bedding items.

The sudden spike in demand for Indian cotton fueled a speculative boom in Bombay. Those engaged in cotton trade were flush with cash. 

Traders deployed their new riches in the share market. 

The Bombay Stock Exchange (BSE) was founded in 1875. Before that, Gujarati and Parsi traders and brokers would gather at different locations in Bombay to trade shares. 

The three most popular locations where trading took place were: The junction of Medows Street and Rampart Row, Bazargate, and the Sugar Market at Mandvi.

Bombay in 1865. Source: Illustrated London News, 1865

New joint-stock companies were mushrooming. Shares of companies that didn’t exist until a few years ago were skyrocketing. Ads for new share issues occupied prominent places in newspapers.

Further fueling the speculative mania was the aggressive lending by financial institutions such as the Bank of Bombay. 

Speculators borrowed money from banks to buy shares. They were confident that stock prices would keep rising. Forward contracts were called “time bargains” at the time. Traders used “time bargains” to bet on soaring stocks. 

Premchand Roychand , the Director of Bank of Bombay, was the big bull of his time. Every new company wanted him on the board. Every merchant wanted tips and advice from him. The working class asked him which shares to buy. Premchand Roychand was pretty liberal in dispensing tips and advice.

Premchand Roychand

By 1864, there were more than 1,000 stock brokers in Bombay. Stock tips, rumors, and forecasts were abound.

Ordinary citizens could no longer stand on the sideline as people buying shares were stuffing their tijoris with money. Civil servants, newspaper editors, clerks—people from all walks of life wanted a piece of the new riches.

The British probably sensed that the speculation was getting crazy. Sir Henry Bartle Frere, the Governor of Bombay at the time, warned civil servants in November 1864 against participating in the speculative mania. He refused to promote anyone who disobeyed his order.

But few paid attention to him. A British official named J.M. Maclean reportedly said:

“I have made more money out of these shares than I have saved during all my service in India and I don’t mean to give up.”

It’s difficult to persuade such people to stay away from the opportunity that changed their life and focus on the boring, low-paying old jobs.

Would you listen to Sir Henry Bartle Frere when you have seen the shares of Back Bay Reclamation jump from Rs 5,000 to Rs 50,000? 

Or Bank of Bombay shares with a face value of Rs 500 rise to Rs 2,850? 

Or the Colaba Land Company shares rally from Rs 10,000 to Rs 1,20,000? 

You wouldn’t. 

Hell bent on stopping the speculative mania, especially the “time bargains,” Governor Frere presented the Wager’s Bill. 

Cotton traders, bankers, investors, and even dozens of British firms vehemently opposed it. But Frere managed to get it through the Bombay Legislative Council. 

Frere sent the bill to Viceroy and Governor-General John Lawrence to approve it and sign into a law. Before Lawrence could sign it, the American Civil War had ended in May 1865 and the bubble had burst. 

Cotton prices crashed amid fears that the British mills would resume importing cotton from the United States. 

Cotton exports from India fell so badly that they didn’t reach the 1865 levels again until 1890. 

When the bubble burst, the Back Bay Reclamation shares fell 96%. The Bank of Bombay shares plunged from Rs 2,850 to Rs 87. Buyers and sellers both defaulted when the “time bargains” matured in July 1865. 

Some of the wealthiest merchants including Behramji Hormusji Cama, Rustomji Jamsetji Jejeebhoy and Kharshedji Furdunji Parekh went bankrupt. 

Ordinary people were left without jobs. 

The population of Bombay declined 21% from 816,000 in 1864 to 644,000 in 1872 as migrant laborers fled home.

It was the first market bubble in India. But the world has seen several bubbles of epic proportions before and after. 

The South Sea bubble (1720), the Mississippi bubble (1720), the British railway bubble (1845–1850), Japan’s stock market and real estate bubbles (1980s), the Dot-Com bubble (2000), and the US housing bubble (2003–2008) are some of the most well-known ones. 

I’m going to dive into the history, behavior, and catalysts of stock market bubbles. I’m no expert. So I’m gonna borrow ideas from the ‘real’ experts to make my arguments. 


The market cycle

Markets have followed a specific pattern for centuries. 

People spot a lucrative opportunity that offers big returns. They rush to exploit it. Prices start going up as people are willing to pay a bit more to participate in the opportunity. The future looks bright. 

When prices get too high, the potential for high returns starts diminishing. Investors get uncomfortable and look for opportunities elsewhere. 

Prices start declining. Some sell in panic. And it becomes an attractive buy again. The cycle repeats itself over and over again. 

Economists have divided market cycles into four different phases:

Market Cycles
  1. Accumulation phase: Market is hitting the bottom. Smart and early investors have started accumulating. Sentiments are skeptical, and valuations attractive. 
  2. Mark-up phase: Market starts moving higher. The majority investors turn bullish and pour money. New investors jump in due to the fear of missing out. Investors sitting on the sidelines join the rally and find themselves making easy money.
  3. Distribution phase: Market sentiments are mixed. Some predict an impending crisis while others expect further upside. Prices stay range-bound. Investors are filled with both fear and hope. Quick boomlets give a perception that markets have taken off again. Smart money starts exiting.
  4. Mark-down phase: The most painful phase of the cycle. The knife is falling. There is panic all around. Those who bought during the Distribution phase see their investments plummet below the buying price. Most of them end up selling at a loss. 

Market cycles come in different shapes and sizes. Sometimes a phase lasts only a few weeks and sometimes it could last years! 

Moreover, a long-term bull market could witness multiple short-term sell-offs that make investors believe that a bear market is on the horizon. Even bear markets have some short-term boomlets sprinkled in. They make it incredibly difficult to spot the top and bottom of the market. 


Market bubbles: A bull run taken too far

The word ‘bubble’ has become so common in the modern financial lingo that it has begun to lose its meaning. 

Analysts and economists are predicting a bubble in every asset class. There is too much of bubble noise. 

Smart people now have easy access to public platforms where they can be heard by the masses. They express their views publicly with just a few taps. And they know that pessimism has the power to grab people by the eyeballs and make them pay attention.

Most of the so-called bubbles that analysts are warning about could just be the regular bull runs. 

Not everything is a bubble. A bubble is something that happens when a euphoric bull run is taken too far. 

I believe a bubble is when an asset rises to an unsustainable level and offers no possibility of recovery to investors for about a decade, or maybe longer.

Noble Prize-winning economist Robert Shiller writes in his book Irrational Exuberance that a bubble occurs when we see the following symptoms in the market:

  • Skyrocketing prices
  • Stories of people getting notoriously wealthy
  • Experts justifying why we are not in a bubble
  • Those sitting on the sidelines envy the newly wealthy and jump in due to FOMO

Shiller wrote in Irrational Exuberance that a speculative bubble is a:

Situation in which the news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”

William Bernstein believes the best way to identify a bubble is to look at the sociological indicators rather than the economy or stock market. He looks at the following signs:

  • Everyone around you is talking about that asset. It’s time to worry if people getting rich don’t have expertise in finance/that field
  • People start quitting their steady jobs to become a full-time trader, investor, real estate broker, etc.
  • When a sane voice warns about the fad asset, people start attacking him vehemently for not seeing what they see
  • Market predictions become more and more outrageous

Any asset that has gone up sustainably for a few years is called a bubble today. In reality, bubbles can be identified and understood clearly only in the hindsight. 


Bubble behavior: Inside the investor’s mind

1. A convincing story

Everything in the global financial system is built on stories and expectations. Take one of them out of the equation and the structure collapses. 

Investors put their hard-earned money in stocks because they have certain expectations backed by stories. 

A powerful storyteller can turn a fraudulent scheme into a multi-billion dollar business (Theranos). They create expectations in our minds that convince us to shed our disbelief take big risks. 

Howard Marks says the biggest hallmark of a bubble is the presence of “bubble thinking.” Investors take a grain of truth and run with it. A powerful story taken too far is the bubble psychology.

2. I’m one of them!

We read or hear that an asset is the ‘next big thing.’ It holds a huge promise. At first we pay attention to these stories from the sidelines. We are still skeptical. 

As months and years pass, the story becomes more real. A greater number of people have been swept by the new wave. Some still sit on the sideline but only for so long. At some point you too begin to believe in the story.

Investing in an asset that everyone else is investing in makes us feel like we belong to a group. And when it’s about something exciting, we definitely want to belong to that group.

We are social animals. If something is popular, we assume by default that it must be good. Our behavior is same when we look at a popular asset. Social proof makes us shed our skepticism.

Social Proof

In the 1990s, the story was that the Internet would change the world. It was a powerful one. An increasing number of people were using the Internet. They could buy books, chat with friends, send documents, and trade stocks over the Internet. 

People could see how everything was changing right before their eyes. The Internet did change the world. But the change was happening at its own pace. 

Investors’ greed and optimism was running at a whole different pace. The gap between the real and perceived pace of Internet transformation got investors to pay too much for Internet stocks. They were willing to pay any price to participate in the new Internet story.

Many a times, an asset becomes a bubble not because it was a terrible investment or investors were wrong about it…but because investors paid way too much for it.

3. Catching the FOMO virus

The early speculators and investors are getting richer by the day. Some of your colleagues and neighbors have already joined the rally.

It’s painful when you are earning 10–12% annual returns and the guy who participated in that rally is up 150% for the year. Some of us say f*ck it and pull out the wallet. We don’t want to miss out on the future rally. 

People catch the FOMO virus when they see others getting richer with little risk, effort, or expertise. 

Some people are not blind to bubbles. They just find it hard to stay on the sideline while the asset is soaring. Citigroup CEO Chuck Prince told a newspaper in July 2007, when the US real estate bubble was near its peak:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

It’s not just the regular folks like you and me who give in to the fear of missing out. Even the smartest of us can’t keep calm when ‘everyone’ is making it big except us. They surrender to the temptation.

For example, Sir Isaac Newton — The guy whose name we have read a hundred times in school and college. 

The South Sea Company was formed in 1711 to sell African slaves to Spain’s American colonies. It later engaged in a complex scheme to convert the British government debt into its own shares. In exchange, the South Sea Company received a monopoly on trade with the South Seas and South America.

Newton invested a large portion of his personal net worth in the shares of the South Sea Company in 1713.

He held the stock for about seven years. The South Sea Company rose from £128 in January 1720 to £330 per share in March 1720. He exited at a handsome profit.

But the shares kept soaring in April, May, and June. The same stock that Newton sold at £330 in March had more than doubled a couple of months later.

Newton felt terrible for having missed such a wonderful opportunity. He didn’t want to miss the further gains.

So Newton invested his fortune in the South Sea Company at around £700 per share, expecting it to go even higher. The stock held up pretty well through early August 1720.

But when the prices became unsustainable, foreigners and other investors started taking some risk off the table. It triggered a major decline in late August. And the bubble finally burst in September 1720.

Newton lost 90% of his investment. He reportedly lost £20,000, equivalent to about £3 million (Rs 28 crore) in today’s terms.

Source: Marc Faber, ‘The Gloom, Boom & Doom Report

King George I, poet Alexander Pope and most members of the Parliament had also speculated on the South Sea Company. They all lost sizable chunks of their personal fortunes.

After the South Sea bubble burst in 1720, Newton famously said:

 “I can calculate the motion of heavenly bodies, but not the madness of people.”

4. They are where I want to be

Why do investors fear missing out on potential gains despite knowing that the valuations have detached from the fundamentals? Because they don’t want to be left poorer relative to their peers and neighbors.

Wipro shares gained 2,500% in 13 months during the Dot-Com bubble. The guy who invested Rs. 1 lakh in Wipro in January 1999 had more than Rs. 20 lakh in January 2000.

Wipro stock during the Dot-Com boom

He was jumping with excitement. Flaunting his wealth. Go back to late 1999 and try telling his friends, neighbors, relatives, and colleagues not to buy Wipro shares. The moment you turn around and leave, they would laugh at you and call you a dumbf*ck.

According to a study, what investors fear deep down is not the risk of loss, but the risk that they could do poorly compared to their peers. 

And they have legit reasons to think that way. 

Let’s say everyone in your neighborhood got 5x richer while you were still stuck in the same old financial position. 

Now the schools, restaurants, properties, etc. in your neighborhood will get more expensive.

You don’t want to be left sulking in the end. So, you join the crowd.

An example of this behavior was seen during Japan’s real estate and stock market bubble of the 1980s. In the late 1980s, there were at least 20 golf clubs that charged a membership fee of more than $1 million!

A Japanese golf lover who didn’t participate in the bubble rally would not be able to afford any of these golf clubs. He is left poorer than his peers.

When a bubble bursts and everyone loses money, you’ll not feel that bad because everyone has lost. If it was only you who lost, you’d feel terrible. 

5. The fool looks for a greater fool

In a euphoric market ‘caution’ becomes just a word in the dictionary. 

The Greater Fool Theory comes into effect. Speculators buy the asset at any price because they are confident they will easily be able to sell it at a higher price days or hours later, just like someone else sold it to them.

This is the moment that starts testing the patience of long-term investors. The market is a complex system with a bunch of different participants, each with a different goal, strategy, and time horizon.

A short-term trader looks at stock A. It has gone up from Rs. 60 to 200 in two months. He buys it at 200 hoping it would go up to 210 or 220 in a day or two. 

He is not worried about the fundamentals, valuation, management, etc. All he wants is a buyer who will pay a little more tomorrow. He isn’t worried about 5–10–20 years of business growth. 

A long-term investor struggles to find bargain opportunities for months or years. Just like short-term traders, they have seen the market scale new highs. Many of them lose patience. 

They convince themselves that the collective wisdom of the crowd is greater than their own. Or they fear missing out on further gains. So a long-term investor suddenly starts behaving like a short-term speculator.

6. Skeptics sound stupid

Skeptical voices emerge when the balloon has inflated to uncomfortable levels. They warn the public of the bubble that could burst anytime. 

Initially, people pay close attention to them. The skeptics are respected. They get invited on TV. They write columns sharing their points of view. 

But the market continues to scale new highs. It’s been months or years since the experts started warning about the bubble that is about to burst.

Nothing has burst. The asset continues to rally. More people are getting richer. Heck, some have even left their steady jobs to become a full time trader or investor. Some have retired on an island, thanks to their new riches.

Mr. market has made the skeptical voices sound stupid. People stop paying attention to them. 

The skeptics can repeat their warnings only so many times, especially when they have started looking like a fool to the public.

A speculative mania could last much longer than you and I can anticipate. That is a major challenge even for people who know that the market is in bubble territory.

Author Jason Zweig wrote an article titled Baloony.com for Money magazine in May 1999 when most technology stocks were doubling every few weeks.

 He warned investors against buying Internet stocks at crazy valuations. But the crowd was so optimistic about the Internet’s potential that they used all their might to ridicule and mock Zweig.

Every day for months, I received dozens of emails calling me an idiot, a moron, a dinosaur, and a seemingly endless variety of anatomical obscenities,” recalled Zweig. The emails stopped only after the bubble burst.

7. Smart money on its way out

Some smart investors and money managers start selling their positions to book profits when euphoria is at its peak. They want to take some risk off the table.

They typically sell over a few weeks or months to balance the risk of loss with the potential for further gains.

It could be incredibly difficult for anyone to determine when a bubble would burst. Only a few lucky ones exit at the peak. Most people get burned, some a little less, some a little more.

Here’s an example of a smart money manager who exited near the top to enjoy hefty returns. But he jumped back in due to FOMO and got burned big time.

In late 1999, billionaire hedge fund manager George Soros and his right-hand man Stanley Druckenmiller concluded that a massive sell-off in tech stocks was just around the corner. 

Druckenmiller himself is among the greatest hedge fund managers of all time. He warned his team that the sell-off is going to be brutal.

He was quoted as saying, “I don’t like this market. I think we should probably lighten up.” By the end of January 2000, he had sold most of his tech holdings and was sitting in cash. A masterstroke!

But the markets kept soaring day after day, week after week. He couldn’t bear the pain of not taking advantage of the rally. Druckenmiller loaded up tech stocks in March 2000.

He hoped that tech stocks would keep scaling new highs. The bubble burst a few weeks after he loaded up. By April 2000, George Soros’s flagship Quantum Fund was down 22% year to date.

Stanley Druckenmiller said in an interview in 2013:

“I bought the top of the tech market in March of 2000 in an emotional fit I had because I couldn’t stand the fact that it was going up so much and it violated every rule I learned in 25 years.”

8. Panic and bloodbath

It takes only a small event to prick the bubble. 

Once a bubble bursts, there is no chance of it inflating again. Traders, investors, and speculators are getting crushed due to the shrinking value of their assets. 

Margin calls make it worse, forcing the speculators to sell their holdings at any price. Supply far exceeds demand. Millions of people are left with a lot less than they had only a few weeks or months ago. 

Just as optimism was rising on the way up, pessimism hits peak when markets are crashing. 

When Japan’s real estate and stock market bubbles burst, it led to a stagnation. The 1990s are still referred to as Japan’s Lost Decade. 

The Nikkei 225 index touched a record high of 38,957 in December 1989. More than 30 years later it’s still trading below that level.

Nikkei 225 Index

We get to see only in the hindsight how far things have gone (both on the way up and down). 


Catalysts of bubble behavior

Whenever there is an opportunity to grab buckets full of easy money, the fundamental forces in our brain spring into action. They get us to act the way we do during bubbles.

There are identifiable themes that have catalyzed bubbles throughout the last 300 years. Let’s explore them one by one, starting with the biggest. 

1. Technological breakthroughs

We have countless examples of technological breakthroughs transforming the way we live and work. Think how the Internet and computers have changed the world. 

A radical innovation attracts massive crowds of investors because it promises outsized returns. The excessive optimism could lead to a bubble. But it’s good for the society and economy. 

If investors don’t get lured by innovation, we would be living in a different world today. 

If people refuse to put their money into an innovative idea, it will probably die a slow death or take a long time to bear fruit. 

As the innovation begins to look more and more promising, the company leading the charge gets overvalued. So most investors turn their focus to the “next” leader in the category trading at reasonable valuations. 

Tesla stock jumped 1,000% between September 2019 and September 2020. The company is transforming the global automobile industry. It has accelerated the shift from internal combustion engines (ICEs) to electric vehicles. 

Tesla stock

But Tesla became highly overvalued in 2020. Investors who missed buying it at reasonable valuations poured their hard-earned money into the “next” Tesla. The most promising “next” Teslas seemed to be Nikola, Li Auto, and Nio. 

Nikola has never made a single vehicle in its existence. But it became even more valuable than Ford in June 2020 as speculators drove up the price. 

The tech boom that began in 1990 saw the Nasdaq Composite Index rise 10x by March 2000. 

The bubble burst in March 2000 and by 2002 the Nasdaq Composite Index had lost 75% of its market value. It took the index another 13 years to regain its 2000 highs. 

Nasdaq Composite Index during Dot-Com boom

Did investors go crazy en masse during the Dot-Com bubble? Probably not. 

Investors were witnessing new technologies changing the way we live in real time. They firmly believed in the potential of the Internet. 

They were convinced that they could get rich fast if they exploited the opportunity that was changing everything around them. 

Tech stocks were delivering more returns in a month than non-tech stocks delivered in years and decades. 

Yahoo! Inc. was trading at a P/E ratio of — hold your breath— 2,000! 

Cisco’s market capitalization surpassed $600 billion. According to the American economist Burton Malkiel, Cisco’s implied growth rate indicated that the company would become larger than the US economy by 2020. 

In 1999 alone, there were at least 100 IPOs that popped more than 100% on the first day. These were too tempting opportunities for speculators to pass up. 

Were speculators building skyscrapers out of thin air? No. 

Duke University conducted a survey of the chief financial officers in March 2000, right before the bubble started bursting. 

Eighty-two percent CFOs said the stocks of their companies were “undervalued.” Only 3% believed their stocks were overvalued. The rest felt their stocks were correctly priced. 

Investors were not wrong about the Internet in the 1990s. They just paid too much and anticipated things to change a lot faster.

The innovation took its own time to percolate through every aspect of the society and economy. Dozens of companies went out of business when the bubble burst. But their innovative business models are still here.

2. A charismatic hero

Tesla’s market cap stood at $442 billion in September 2020, roughly the same as the world’s six largest automakers combined! 

Source: JPMorgan Asset Management

Will Tesla still be as valuable if Elon Musk is taken out of the equation? I highly doubt. 

Let’s look at one of the greatest stock market bubbles of all time to understand what a persuasive and charismatic leader with a lofty vision can do to investors’ psyche. 

They show investors a vision that gets them (investors) to pull out their wallets and pay any price to get onboard.

France was experiencing a sovereign debt crisis 300 years ago. It needed a miracle to keep the government and the economy going. When King Louis XIV died in 1715, the French treasury was nearly bankrupt. The metallic currency was fluctuating wildly in value. People were losing faith in the system. 

The French Regent for the juvenile King Louis XV found a charismatic savior in the Scottish economist John Law. 

In 1694, Law fought a duel with Edward Wilson over the affections of a woman. He killed Wilson in the duel. He was sentenced to death for the murder. However, Law managed to escape to Amsterdam and later arrived in Paris. He had become a prominent economist by 1715. 

The French Regent trusted John Law because he had worked as the Controller General of Finances for the Regent. 

In 1716, John Law established a private Banque Générale, which a year later became France’s central bank aka Banque Royale. 

To resolve the government’s debt crisis, Law proposed that the Banque Royale start accepting deposits and issue paper money payable in the value of metallic currency at the time the banknotes were issued. 

The strategy worked. The French economy achieved financial stability that seemed impossible only a few years ago.

John Law became famous and powerful. The only person more powerful than Law was King Louis XV himself. Even though the Banque Royale was owned by the French government, it was effectively controlled by John Law. 

In August 1717, Law launched the Companie des Indes aka the Mississippi Company. Riding high on the success of Law’s economic policies, the French Regent gave the Mississippi Company complete monopoly on trading rights with French colonies. 

A couple of years later, John Law devised an ambitious plan to reduce or even eliminate the French government’s sovereign debt. 

Investors who held the French government debt could exchange their bonds for shares of the Mississippi Company.

John Law promised shareholders an impressive 120% profit based on expected income from the trading monopoly. He received more than 300,000 applications for the 50,000 shares he offered.

Demand for the Mississippi Company shares was soaring. The Banque Royale, which John Law controlled, kept printing more and more paper banknotes. Inflation was running high and so were the Mississippi Company’s shares.

The rising inflation triggered a run on the Banque Royale in May 1720. The French government was finally forced to admit that the value of paper money in circulation was much higher than the amount of metallic currency. And the bubble began bursting. 

On May 21, 1720, the French government issued an order to gradually depreciate the value of Mississippi Company shares to half their nominal worth by the end of the year. 

The public outrage forced the Regent’s Council to restore the Mississippi shares at their original value on May 27. But the Banque Royale stopped payments in metallic coins. 

When the Banque Royale reopened in June, people rushed again to withdraw their deposits. And they were no longer interested in owning shares of the Mississippi Company. 

By November 1720 the company’s shares had become worthless. John Law was forced to leave France. He died in Venice in 1729. 

3. Loose monetary policies

Japan’s economy was destroyed during the World War II. The country began picking itself up piece by piece after the World War. 

Thanks to the sheer hard work and dedication of its people, Japan became one of the world’s fastest growing economies in the 1960s. 

The world soon began respecting the Japanese for their high-quality, high-tech products. 

In the early 1980s, it seemed like Japan was on track to overtake the United States as the world’s largest economy. Japanese cars, electronic goods, and heavy machinery dominated the global trade. 

Japanese government started deregulating the financial markets in the 1970s, allowing banks to actively seek new customers. 

Tokyo further loosened its monetary policy in the 1980s. Interest rates fell dramatically and money supply went up! Individuals and corporations had easy access to credit. 

Due to the loose monetary policy, Japan experienced simultaneous bubble in the stock market and real estate in the 1980s . 

Japanese corporations invented “zaitech” or “financial engineering.” It made speculations part of a company’s earnings statements. 

Corporations had access to low-interest loans and they could easily raise funds from the market. 

Many companies were recycling a huge portion of fresh funds into speculative bets in the stock market. The Nikkei index soared higher. 

Companies were showing the profits from speculative bets as part of their earnings. The inflated earnings further fueled the stock market rally. It became a vicious cycle. 

By 1989, “financial engineering” accounted for about 50% of profits of some of the largest corporations in the country. 

Nikkei index rose 10x in just a decade. Residential real estate prices were also ballooning. Land prices were marching up.

The Japanese Imperial Palace had become more expensive than the entire real estate in the state of California. The Palace (area 3.41 square km) was worth $852.5 billion

The entire GDP of Japan in 1989 was $5.1 trillion. India’s GDP was $296 billion in the same year. It means the Imperial Palace was worth almost 3x India’s GDP in 1989!

Everything was unsustainable. The Japanese government was growing uneasy. The Bank of Japan started tightening the monetary policy in May 1989 by raising interest rates. 

They raised interest rates again later that year. They didn’t stop there. The Bank of Japan raised interest rates five times in the first eight months of 1990 to check the rising real estate prices! 

Nikkei index began plummeting. The government attempted to revive the stock market and prevent a recession. But the bubble had burst — both the stock market and real estate. 

The Japanese real estate values have declined more than $8 trillion since their 1989 peak. More than 30 years later, the Nikkei 225 index is still trading below its December 1989 high. 

A more recent example

Loose monetary policy was also blamed for the US housing bubble that led to the 2008 Great Recession. 

The Dot-Com bubble burst in 2000. Stocks were plummeting. Then the 9/11 happened and whole America went into panic mode. Federal Reserve chairman Alan Greenspan dropped interest rates to just 1% to revive the economy. 

The Dot-Com bubble had left a scar on people’s minds. They believed stocks — especially tech stocks — were risky. 

So they started exploring opportunities in other assets. The record low interest rates gave them an opportunity to buy real estate without breaking a bank. The Wall Street firms and bankers were also borrowing heavily. 

Lenders lowered their lending practices, enabling people with weak or subprime credit to buy homes. 

Real estate was becoming everyone’s favorite asset to own. By 2005–06, people were quitting their jobs to become real estate brokers. 

In hindsight, Alan Greenspan said, “We had a bubble in housing. I really didn’t get it until very late in 2005 and 2006.” 

Yale economist Robert Shiller warned that home prices were overvalued and the correction could last several years. 

A large number of homeowners struggled to pay their mortgages when the low introductory rates reverted to regular interest rates. 

Increasing foreclosures led to the collapse of the US real estate prices. It directly affected the banks and other financial institutions that lent heavily during the boom to people with subprime credit.

When the markets fell in 2008, PIMCO CEO Mohamed El-Erian called his wife and asked her to withdraw as much cash from the ATM as possible. He told her the banking system was going to collapse. But the government and Fed’s printing machine stepped in.

4. Removal of trading barriers

Speculative behavior orgasms every time barriers to speculation are removed or reduced. 

Up until 150 years ago, the stock prices used to be hand-delivered via written messages. Since the prices changed every day, they would become irrelevant when sent over long distances. So people used to send aggregate summaries of the day over short distances.

Edward Calahan invented the ticker tape in 1867 that would transmit the stock price information. It could relay prices over long distances via telegraphic lines. 

A couple of years later Thomas Edison developed the Universal Stock Ticker that used alphanumeric characters and boasted a printing speed of one character per second. 

Thomas Edison’s Ticker Tape

In just a few short years brokers all over the United States had a ticker tape installed. Investors could get the stock price quotes in “almost” real time by visiting a place (usually a broker’s office) that had one of these ticker tapes. 

It democratized the access to financial markets and increased the flow of information. 

A lot of experts argued that the ticker tapes should reduce the possibility of stock market bubbles because people would have an increased access to information. It meant the prices would be closer to their real value. 

Instead, speculations and bubbles became more likely as the flow of information increased. Ticker tapes reduced the barrier to speculation. 

 Newbie traders could easily trade stocks. They could monitor the stock prices in real time. Trading became a time-sensitive affair. 

According to a study, the US House Report on the Control of Money and Credit in 1913 criticized the telegraph-based ticker tape technology that made it incredibly easy for speculators to access the financial markets. 

The broadcast ticker vastly increased the audience that could be exposed to and perhaps react to activity manufactured through matched or wash sales,” notes the study.

One of the things fueling the Dot-Com bubble was the removal of barriers to speculation. People no longer had to visit a broker’s office to check the real-time stock prices. They could do it on their computer.

Discount brokers encouraged traders and investors to bypass the expensive full-service brokers. The reduction in trading costs encouraged an army of first-time traders to speculate on hot stocks. 

Online brokerage firms further fueled the speculative behavior. People could execute transactions at will based on the real-time information. 

Traders could interact with one another in different online forums, being fed with the stories of people making 379% gains on ABC stock in three months. 

The constant supply of mental stimulus encouraged them to engage in even more speculative bets more aggressively.

Fast forward to 2020 and trading costs — one of the biggest barriers to speculation — have vanished. 

Online trading firms are offering zero-cost trading to a crowd of investors, traders and speculators who have the latest information on stock price movements on their smartphones. 

Whether you are panicked or excited, the removal of almost all the barriers to trading/speculation has made it easy for you to overreact to short-term trends. 

5. Big Daddy will save us

Having learned lessons from the past economic crises, the US government and Federal Reserve came up with a massive stimulus package during the 2008–09 economic crisis. 

Obama administration announced a $787 billion package. The US Treasury spent another $700 billion under the Troubled Asset Relief Program (TARP) to rescue the ailing banks, insurance firms, automakers and other companies. The total spending went above $1.5 trillion. 

In 2020 when the China Virus pandemic forced the world into a lockdown, Trump administration announced a $2.2 trillion economic stimulus. They were sending free money to individuals, small businesses, large corporations, etc. The US government hasn’t stopped there. A bigger, more aggressive stimulus package is in the works. 

What’s happening here? Politicians are playing their game to get into the good books of the public. But they are also encouraging bad behavior. 

It’s shocking that the US government gave out hundreds of billions of dollars to giant corporations. You might argue that the money helped prevent job losses. Maybe it did. Maybe it didn’t

When corporations and individuals grow confident that the government will give them trillions of dollars of free money in bad times, their actions become more irresponsible and undisciplined. 

Let’s go back 50 years to see how people behave when they know that Big Daddy is going to save them…when they grow confident that risk and losses are just meaningless words. 

Kuwait witnessed a massive oil boom in the 1970s. Flush with oil money, the new lot of wealthy people started playing with the stock market. 

The Middle-Eastern nation had a bear market in the late 1970s. But the government stepped in and became a major buyer to thwart a steep decline in the market. 

The Kuwaiti speculators grew confident that the government would rescue them if anything went wrong again. 

Back then Kuwait had only a small number of stocks that traded over the counter. After the bear market was taken care of, traders and speculators entered the market again to speculate in a big way. Why wouldn’t they when there was no risk of losing money?

The speculators were propping up stocks every day. Those stuck in traffic would use their car phones to place orders with their broker.

During Ramazan holidays when people had little else to do, they would engage in trading stocks for fun. It became a source of entertainment for them. They were using post-dated checks for margin calls. 

Shares were doubling every few weeks. So speculators were writing bigger post-dated checks than the money in their accounts. 

They believed that the stocks they held would grow to match or exceed the amount scribbled on the post-dated checks before they came due. They had done it again and again, coming up with the money by selling at a profit and covering the post-dated checks. 

Many speculators were writing post-dated checks double or triple the current value of the stocks they were speculating on. 

Speculation drove the total market cap of Kuwaiti stocks from $5 billion in 1980 to $100 billion by 1981! 

Everyone was getting richer. Then came the infamous oil glut of the 1980s. Global oil prices started declining due to a surplus of crude oil. 

Many wealthy speculators who had accumulated oil money were suddenly unable to meet the obligations of their post-dated checks. The bubble started bursting. 

And unlike his predecessor, the new finance minister of Kuwait was no longer interested in propping up the stock market. 

When the bubble burst, $90 billion worth of post-dated checks became worthless. Just for comparison, Kuwait’s entire stock market was worth $100 billion at its 1981 peak. 

6. The gold rush

Speculative mania gripped Bombay in 1861–65 because cotton had suddenly become the “white gold.” The increased demand for cotton created a new breed of rich people who thought making money in speculative bets was as easy as talking to your best friend. 

About 60 years after the Bombay bubble, the American state of Florida experienced a real estate boom of massive proportions. Florida has had some beautiful beaches, but the state’s real estate sector was still underdeveloped in the late 19th century. 

Wealthy individuals who traveled abroad to enjoy the warmer climate found themselves in a complex situation. Retirees were also left with limited options to settle in a warmer climate. 

The World War I disrupted their foreign travel and then came the Spanish Flu that brought travel to a halt. 

Looking for a new retirement and vacation spot with a warm climate, some wealthy individuals ventured into Florida. They helped develop the community. They started building hotels, restaurants, homes, shopping centers, etc. 

Florida was soon flooded with new residents and tourists. According to Christopher Knowlton’s book Bubble in the Sun, a large number of people started buying and selling real estate, creating wealth at a blazing fast pace. 

Six million people came to Florida in just three years. In 1925 alone came 2.5 million people looking for jobs. They were not disappointed. Most of them got new jobs in real estate. 

Construction companies were building houses that they sold at 200% and 300% profit margins. They didn’t have to worry about finding buyers because customers were standing in queue with their wallets out. 

There were riots. Desperate buyers were throwing checks at developers to be among the lucky ones to buy a property. Developers were using barrels to collect massive piles of checks.

The city of Coral Gables was called “the only city in the world where you can tell a lie at breakfast that will come true by evening.” That’s how fast the property prices were rising.

A beach-front property was purchased for $775,000. Next month, the owner sold it for $1.5 million.

Another beach property was purchased for $3 million and sold three days later for $7.6 million! 

It’s not just the people pouring in from other states that were making money in real estate. 

By 1925, the Miami Police Department faced a sever shortage of staff because a growing number of police officers were quitting their jobs to become real estate agents.

Dozens of real estate developers became insanely wealthy. When the prices stagnated or started declining a little, “Florida’s real estate kings” believed that it was just a temporary thing. 

According to Knowlton, none of them thought of taking some money out of the real estate business. They were busy celebrating “their spectacular success by buying new cars and building new homes.”

Florida’s real estate kings were by now enormously successful. And yet the greater their success, the harder it was for them to see their success as something separate and distinct from their own labors; to believe that circumstances, even luck, might have played a part in what they had accomplished.

There came a point when buyers could no longer afford the new houses being built. Prices started falling and the paper wealth of real estate developers started vanishing into thin air. 

The biggest real estate developers in Florida defaulted when the bubble burst. Lenders who gave money to these developers received less than a penny for every dollar they were owed. 

Properties that sold for millions of dollars just a few months prior were available for under $50,000. At least 80% cities and towns in Florida defaulted on their municipal bonds. 

7. Media and the market bubbles

Stories hold the power to move the markets. Investigative journalists can bring down a stock by exposing fraud and wrongdoing. That’s a good thing. The positive side of financial journalism. 

But the 24/7 bombardment of shrill and sensational news also has the power to influence investor behavior. 

In their attempt to make news more interesting, grab more eyeballs, and generate more ad revenues, financial media outlets churn out sensational headlines that not only grab investors’ attention but also press their panic/FOMO button. 

Their attention-grabbing headlines and screaming anchors exacerbate market panics. 

Nobel Prize-winning economist Robert Shiller says that the media are the “Fundamental propagators of speculative price movements through their efforts to make news interesting to their audience.”


Can you act rationally in a bubble?

Robert Shiller was right about both the Dot-Com and the US housing bubbles. But he has said that being right about past bubbles is no guarantee that you’ll be right about the next one. 

Shiller is not wrong. 

Charles Mackay published the book Extraordinary Popular Delusions and the Madness of Crowds in 1841. It’s still one of the best books ever written on speculative mania. At the time, few people had studied speculative bubbles as deeply as Charles Mackay. 

Just a few years after publishing the book, Mackay himself contributed to fueling the British railway bubble that started bursting in late 1845, according to mathematician Andrew Odlyzko

Oblivious to the bubble forming right before his eyes, Mackay was encouraging people to double down on railway stocks that were flying high. 

Mackay never publicly acknowledged that the railway mania he was propagating was a bubble. But the British railway stocks fell 70% when the story fizzled. 

In hindsight, we should have sold stocks at the peak of 2007 and bought big in early 2009. Or exited tech stocks in 1999 and bought them back in 2002. Makes perfect sense. You might have made boatloads of money. But we can never forecast the peak and trough of the market. 

During a bubble, our own mind experiences the same emotions as the broader market. We fear missing out the opportunity of a lifetime when everyone around us is getting richer.

Stanley Druckenmiller is one of the smartest hedge fund managers of all time. He had an army of super smart experts. But he still ended up buying tech stocks near the peak of Dot-Com bubble when we know in hindsight that he should have been running away.

Stanley Druckenmiller knew that tech stocks were a bubble. He just couldn’t see others clocking impressive returns while he sat on the sideline.

If Druckenmiller couldn’t…if the guy who wrote one of the best books on bubbles couldn’t…if Sir Isaac Newton couldn’t, what are the chances for average people like you and me?

If you want to make big money in a bubble and get out of it right before it starts bursting, you need to be incredibly smart, incredibly disciplined, and incredibly lucky. 

I can tell you to be cautious when valuations get uncomfortable. I can tell you to be disciplined. 

But truth be told, I don’t know how I myself will behave in a speculative mania. I would want to be smart and disciplined, but I don’t know if I will be. Only time will tell. 

It’s not that everyone goes mad or starts behaving irrationally during a market bubble. It has more to do with the human nature. Bubbles will be around as long as we have our emotions. 

The best we can do to avoid permanent loss of capital is to not have all our money in a single asset class. 

And we should re-balance at least once a year to stick to our asset allocation. Re-balancing may hurt our returns when one asset class is flying high, but it also ensures that you’ll be hurt far less when that asset collapses. Another wise thing to do is to seek the help of a fee-only financial advisor who can check your impulsive behavior.

God! Too much of rambling. I need to stop now.

Signing off. But do subscribe to my newsletter.

– Vik


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