Bubbles and Manias

What a bubble is — and why it is so hard to name in time

A bubble is a price that has risen far above any reasonable estimate of the asset’s value and stays there because buyers expect to sell to someone else at a higher price. The definition is simple; the diagnosis is not, because “any reasonable estimate of value” is exactly what the people inside the bubble disagree about. Eugene Fama’s challenge to the idea is serious: if bubbles were identifiable in advance, a sharp run-up should predict poor returns afterwards, and on average it does not. Many assets that looked absurdly expensive kept rising, and some of them were right. Greenwood, Shleifer and You took the challenge seriously and found both sides are true. Across U.S. and international industries, a big run-up did not predict low average returns — but it did predict a much higher chance of a crash. Going from a 50% to a 100% two-year return over the market raised the probability of a 40% drawdown within the next two years from about 19% to about 54%; after a 150% run-up it was about 81%. What sharpened the prediction were features of the run-up itself: rising volatility, heavy trading, a surge of new share issuance, and a price path that was accelerating rather than steady. Those two findings, held together, are the honest position. You cannot reliably date the top, and betting heavily that a mania will end soon is a way to be right and broke. But you can recognise that the odds of a large fall have risen sharply, and size the exposure as if they have. • A bubble: a price far above value, sustained by the expectation of reselling higher. • Run-ups do not reliably predict low average returns — Fama’s point. • They do raise the odds of a crash: a 100% industry run-up → about 54% chance of a 40% fall within two years. • Warning signs: rising volatility, heavy turnover, surging issuance, an accelerating price. Two-year industry run-up over the market → chance of a 40% crash within two years — +50%: About 19% · +100%: About 54% ← · +150%: About 81%

The anatomy of a mania: five stages

Charles Kindleberger, building on Hyman Minsky, described manias in five stages, and the pattern has repeated across centuries and assets. **Displacement**: something genuinely new — a technology, a market, a policy change — creates real opportunities and real profits. **Boom**: prices rise, credit expands, and early investors are visibly rewarded. **Euphoria**: valuation methods change to justify the prices (“page views”, “total addressable market”), new buyers who have never invested arrive, issuance surges to meet the demand, and the phrase “this time is different” is used without irony. **Distress**: insiders and early investors sell, credit tightens, the price stops rising — and in a market that depends on rising prices, stopping is enough. **Revulsion**: the asset becomes unmentionable, prices fall far below even sensible values, and the people who were most certain are the ones forced to sell. The dot-com era fits it closely. Netscape’s IPO in August 1995 — priced at $28, closed its first day at $58.25 — announced the displacement. The boom ran through the late 1990s; by December 1999 the cyclically adjusted price-earnings ratio of the S&P 500 had reached about 44, the highest on record. Euphoria peaked with the Nasdaq Composite’s close of 5,048.62 on 10 March 2000. Distress followed within weeks, and revulsion lasted until October 2002, when the index had fallen 78%. The stages are easier to label afterwards than during, and that is the point of learning them: not to call the top, but to notice which stage the conversation around you sounds like. When the valuation method changes, new investors arrive in waves, and issuance accelerates, the stage is late — however long late lasts. • Displacement: a genuine novelty creates real profits. • Boom: prices and credit rise; early investors are visibly rewarded. • Euphoria: new valuation methods, new investors, surging issuance, “this time is different”. • Distress: insiders sell, credit tightens, prices stop rising. • Revulsion: forced selling drives prices below sensible values. The dot-com mania, stage by stage — Displacement — 1995: Netscape IPO: priced at $28, closed day one at $58.25 · Boom — 1996–98: Internet stocks multiply; credit and IPOs expand · Euphoria — 1999 to March 2000: CAPE about 44; Nasdaq closes at 5,048.62 on 10 March ← · Distress and revulsion — 2000–02: Nasdaq down 78% by October 2002

Four centuries of the same story

The famous **tulip mania** of 1636–37 is real but smaller than its legend: the historian Anne Goldgar found that the collapse in early 1637 ruined far fewer people than later retellings claimed — itself a lesson in how bubbles are remembered. The **South Sea Bubble** of 1720 was not small: shares of the South Sea Company rose roughly eightfold in the first half of the year on the promise of trade monopolies and debt conversion, and gave almost all of it back by the autumn; Isaac Newton is reported to have lost heavily after buying back in near the top. In 1929 the Dow Jones Industrial Average closed at 381.17 on 3 September and fell 89% to 41.22 by July 1932; the price index did not regain its peak until November 1954. The Nasdaq fell 78% from March 2000 to October 2002 and did not regain its peak until April 2015. U.S. house prices, which had been called safe because they had not fallen nationally in living memory, fell about a quarter from 2006 to 2012 and took the banking system with them. In 2021–22 cryptocurrencies repeated the pattern at speed: Bitcoin fell about 77% from its November 2021 peak in a year. The cases share more than a shape. Each had a real innovation or a real story at its core; each widened the circle of buyers to people who had never owned the asset before; each was financed increasingly with borrowed money or new issuance; and each left a long aftermath, because a fall of three-quarters needs a quadrupling to undo. The calculator in this lesson measures that aftermath for 1929 and 2000. • Tulips, 1637: real, but smaller than the legend. • South Sea, 1720: roughly eightfold, then almost all of it back within months. • 1929: the Dow fell 89%; the price index regained its peak in 1954. • 2000: the Nasdaq fell 78%; regained its peak in 2015. • Housing 2006–12 and crypto 2021–22: the same shape, different assets. Peak, fall and the long way back — Dow, 1929–32: −89%; peak regained in November 1954 · Nasdaq, 2000–02: −78%; peak regained in April 2015 ← · U.S. house prices, 2006–12: About −27% nationally · Bitcoin, Nov 2021 – Nov 2022: About −77%

How a mania feels from inside

From inside, a mania does not feel like madness; it feels like evidence. Every bias in this subject is pointing the same way. **Extrapolation** (P8) turns a year of gains into an expectation of more, and surveys of investors’ expected returns have been highest after the best past returns. **Social proof** (P10) turns other people’s buying into information. **Lottery preferences** (P6) make a small chance of a life-changing gain feel worth a lot. **Regret** runs in one direction: the pain of watching friends get rich feels sharper than the abstract risk of a loss. And **confirmation** (P7) supplies a steady stream of articles explaining why the old valuation methods no longer apply. The sceptics, meanwhile, look wrong for a long time. Alan Greenspan wondered aloud about “irrational exuberance” in December 1996, with the Nasdaq near 1,300; it then rose almost fourfold before peaking. Robert Shiller’s book of the same name appeared in March 2000, at the top. Being early is indistinguishable from being wrong until the end, which is why so many people who correctly called a bubble lost money betting against it — and why the next lesson is about the limits that keep mispricing alive. One more feature makes manias dangerous to households in particular: they arrive late in a long rise, when portfolios are largest and confidence is highest. The same story that would have been a small bet at the beginning has become a large share of the balance by the end — not because anyone decided to concentrate, but because the winner grew. That drift is where the damage is done. • Inside a mania every bias points the same way: extrapolation, social proof, lottery preference, regret, confirmation. • Sceptics look wrong for years — Greenspan’s warning came almost fourfold before the Nasdaq peak. • Being early is indistinguishable from being wrong until the end. • The damage comes from drift: the winning story becomes the largest position just before it breaks. The warning and the top — December 1996: Greenspan’s “irrational exuberance” remark — Nasdaq near 1,300 · March 2000: Nasdaq closes at 5,048.62; Shiller’s book is published ← · October 2002: Nasdaq near 1,114 — below where the warning was given

What to do about a suspected bubble

The useful responses do not require knowing when the top will come. **Rebalance** (PF10): a rule that trims whatever has grown past its target sells some of the bubble automatically, at rising prices, without any forecast. **Cap position sizes**: write down the most any single story can be of the portfolio, and hold to it as the story grows. **Avoid leverage** on anything in the euphoria stage, because borrowed money is what turns a fall into forced selling at the bottom. And **watch the signs** that raise the odds — rising volatility, surging issuance, new investors arriving, new valuation methods, accelerating prices — as reasons to reduce rather than to add. The tempting response — shorting the bubble — is the dangerous one for almost everyone. A short has unlimited loss, pays to borrow, and can be forced closed by a margin call long before the price comes back to earth. As the next lesson shows, mispricing can widen before it narrows, and the people who are right about the destination are often the ones who cannot afford the journey. Finally, write it into the policy (PF17). A rule written in calm — “no single position above 10% of the portfolio; trim back at each annual review” — will do in a mania what willpower will not, because by the time a bubble is obvious, the people inside it have stopped wanting to sell. • Rebalance: it sells some of the bubble automatically. • Cap the size of any single story, and hold the cap as the story grows. • Avoid leverage in the euphoria stage. • Treat the warning signs as reasons to reduce, not to short. Responses that need no forecast — Annual rebalancing: Trims the winner at rising prices · A written position cap: Stops drift turning a story into the portfolio ← · No leverage on euphoric assets: Removes the forced sale at the bottom · Shorting the bubble: Unlimited loss, borrow costs, margin calls — the dangerous response

Sources

• Run-ups, crash probabilities and the signs that sharpen themGreenwood, Shleifer & You, “Bubbles for Fama” (Journal of Financial Economics, 2019)
• The stages of a maniaKindleberger & Aliber, “Manias, Panics, and Crashes”
• Valuation and the 2000 peakShiller, “Irrational Exuberance” (2000)
• What really happened in the tulip maniaGoldgar, “Tulipmania: Money, Honor, and Knowledge in the Dutch Golden Age” (2007)
• Investor expectations extrapolate past returnsGreenwood & Shleifer, “Expectations of Returns and Expected Returns” (Review of Financial Studies, 2014)