Bubbles

Manias, bubbles, panics, and crashes have been a staple of financial markets throughout history. The first recorded episode dates back to the 17th century when the price of Dutch tulips increased by several hundred percent in the autumn of 1636, only to spectacularly collapse a few months later.

Recent price action around artificial intelligence stocks has triggered a spike in investor questions on whether a bubble is forming in US equity markets. Identifying bubbles before they pop is challenging, yet history can be of help. Although no two historical episodes share the exact same features, patterns have emerged.

As described by investor Ray Dalio's in his book "Principles for navigating big debt crises ," and economic historian Charles Kindleberger in his classic "Manias, panics, and crashes: A history of financial crises ," the following have been some of the key defining characteristics of bubbles historically:

1. Very high valuations, with prices extrapolating large recent gains into the future
2. A large share of asset purchases being financed by leverage
3. A large share of purchases made not because of the fundamental merits of the investment, but in anticipation that the asset can be sold to someone else (a "greater fool") at an even higher price in the future
4. A large number of new investors enter the market; amid widespread euphoric sentiment
5. Easy financial conditions tend to inflate the bubble; a tightening of financial conditions contributes to popping the bubble

Based on this framework, the US equity market does not seem to be in a bubble as we speak. Valuations are high but not excessive. The use of margin debt to purchase stocks stands at sensible levels. Most investors appear to be buying AI stocks for their capacity to deliver earnings; and not necessarily in the expectation of selling positions to a greater fool in the near future. Sentiment is bullish yet not euphoric—AI investment opportunities are not pervasively being discussed in mainstream TV, social media, or in cab and elevator rides, for example. The Fed has so far kept interest rates high, limiting the amount of air that could potentially go into a bubble.

Some of the behavioral aspects of historical bubbles are also currently missing from the wider market. In Kindleberger's words:

"The increase in prices of […] stocks is associated with euphoria; household wealth increases and so does spending. There is a sense of ‘We never had it so good.’ […] Rational exuberance morphs into irrational exuberance […] There is a pervasive sense that it is ‘time to get on the train before it leaves the station’ and the exceptionally profitable opportunities disappear."

In short, if history is any guide, the market does not seem to be in a bubble right now.

However, because the emergence of new technologies has historically provided fertile ground for bubbles to form—dot-com and crypto being the two most recent examples—and that froth may already be surfacing in certain corners of the market today, the situation deserves very close monitoring.

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