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Every once
in a while a bubble forms in a market. Bubbles can occur in any market,
whether stocks, commodities, real estate or as we know from history, even
tulip bulbs.
Market bubbles
are, as the name implies, unsustainable. They are manifest by inflated prices
that go up and up to achieve unthinkable levels for a while, and in some
cases, for a very long while. But like their soap-bubble counterparts, market
bubbles clearly lack durability. They can pop at any time. So inevitably, the
bubble pops, with the unfailing result that prices thereafter quickly drop
back to earth.
In essence,
bubbles are nothing more than an emotional frenzy in which prices climb to
unheard of levels, until the market attains a shocking level of
overvaluation. To achieve this outrageous situation in which price far
exceeds an asset’s value, a bubble involves the near-universal
acceptance of some delusive idea.
One
notorious example is John Law’s scheme in 1716 promoting the virgin
lands surrounding the Mississippi River, which was a ruse that swindled the
entire French nation. The resulting Mississippi Bubble has forever been
regarded as the apotheosis of market bubbles, but it shares with all bubbles
one dominating characteristic.
Even though
prices move far out-of-line with an asset’s fundamental value based on
any prudent measure, people do not react as one would logically think.
Instead of recognising a bubble for what it is,
people instead tend to rationalise why prices are
so high. They try to explain to themselves and others why prices are
supposedly reasonable.
This
attempt to rationalise what is illogical and
abnormal is a unique characteristic of bubbles. But it is not too difficult
to see why this foolhardy thinking happens. When you are living in a bubble,
it is very hard to accept the reality that you are indeed in the midst of a
bubble.
Thus, the
inability to perceive foolhardy thinking is a result of most everyone saying,
doing and thinking the same things. This mutual, identical action reinforces
one's view to mistakenly believe that what they are thinking is correct and
normal instead of what it really is, namely, the erroneous and illogical
pervasive thinking that characterises a bubble.
As an
example, today this rationalisation explains why US
government debt cannot possibly be overvalued because [....]. Go ahead. Fill
in the blank. We have heard the countless reasons why US government debt is
supposedly a safe haven.
In short,
while technology and other circumstances are constantly changing the world,
the common denominator is that human nature never changes. Consequently,
bubbles are possible because people are always willing to believe the
unbelievable, such as the delusory thinking that one is buying a safe haven
with the debt instruments of an over-leveraged government that has made far
too many financial promises.
Only after
it pops does the bubble become obvious. It is only then that the stark realisation dawns on people that they had been living in
a bubble, and the serious questions get asked. To
take but one example from the 2000 stock market bubble, why would anyone have
bought Cisco at $75 a share (which is more than four-times higher than its
current price over a decade later) when it had a market cap more than
20-times annual sales and no earnings when properly accounting for the cost
of employee stock options? But many people did buy it.
Law's
scheme was based on the false premise that the lands of Mississippi were
worth far more than they really were worth. Though false, this premise became
widely accepted. People bought into the bubble, inflating the stock price of
his Mississippi Company. At the peak, price far exceeded value, but this
reality was only recognised only after the bubble
had popped.
Clearly
gold is not in a bubble. It does not follow the pattern of bubbles. Gold is
not widely owned today, which stands in stark contrast to what would be
expected if it were in a bubble. More importantly, instead of gold owners
trying to rationalise a high price, people who do
not own gold are giving reasons not own it.
There is a
bubble today, but it is not gold. It is the debt instruments of the US
government and indeed, other governments that have also made far too many
financial promises. Many of these promises will be broken and many debts
repudiated, but most people do not understand or refuse to accept this
reality. Ignoring prudent financial analysis and even the lessons of history,
they still believe government debt is a safe haven
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