courtesy of flickr.com/photos/amagill/

Now that you have a basic definition of a stock bubble, let’s look at the underlying factors, or what I call the recipe for a stock bubble.  Why do you care to know how bubbles form?  Because bubbles burst.  And when they do, people lose lots of money.  People like your brother-in-law who cashed in his 401(k) to invest in Snuggies stock, who is now living in your basement.  Once you understand the recipe for stock bubbles, hopefully you can see them forming early and steer clear.

Because your brother-in-law needs somewhere to live.

Once again, we turn to The Four Pillars of Investing by William Bernstein to give us the ingredients for a stock bubble. Once two or more of these factors are present in a market, bubbles form (these ingredients come in no necessary order):

The first is a “displacement”, which in modern times usually means a revolutionary technology or a major shift in financial methods.

The second is the availability of easy credit—borrowed funds that can be employed for speculation.

The [third] is that investors need to have forgotten the last speculative craze.

And [finally], rational investors, able to calculate expected payoffs and risk premiums, must become supplanted by those whose only requirement for purchase is a plausible story.

Voila!  The four ingredients.  In order to bring them from abstraction to reality, let’s see if and how each of the factors was present in the bubble burst of 2007, what many call the real estate or housing bubble.

Ingredient One

Were there any technological or financial innovations that transformed the market?  Heck yes! Ever heard of Mortgage-Backed Securities or Credit Default Swaps?  Crafty financial minds came up with new ways to package mortgages as investment tools and created methods to insure them.  Too bad so many of the mortgages these investment tools were built on were “sub-prime”, meaning the lenders defaulted en masse on their mortgage loans.  And when the sub-primers defaulted en masse, the insurance companies didn’t have enough to cover them!

Ingredient Two

Was credit easily available? Hmm, why don’t we ask the dogs and dead people who were offered pre-approved, no questions asked solicitations for credit cards?  Another example, perhaps you’ve seen Maxed Out, where a loan officer assists a mentally handicapped man sign his name on a loan application (the handicapped man was incapable of working or earning an income).  Or this: The mid-2000s gave us NINJA loans (No-Income-No-Job-or-Assets)!

Ingredients Three and Four

According to Bernstein, ingredients 3 and 4 “can be summarized in one word: euphoria. Investors begin purchasing assets for no other reason than the fact that prices are rising.”  Investors were definitely euphoric: in the mid-2000s stocks were going up and up.  The big institutional investors, Bear Stearns, Lehman Brothers, etc were buying and trading all the Mortgage Backed Securities they could get their hands on.  When other institutional investors saw the profits coming in, they jumped onboard.

Unfortunately, bubbles burst.  All of the “profits” and “asset appreciation” were built on speculation and euphoria.  Lehman Brothers went under, AIG got bailed out, and no one is happy.

Hopefully, now that you know what a bubble is and the conditions necessary for their formation, you can keep a cool head and continue diversifying your investments.  Remember, your brother-in-law is going to need someplace to live.

Tags: asset bubble, The Four Pillars of Investing, William Bernstein

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