Wall Street Bubbles

This illustration shows a bull market blowing bubbles labeled, “Inflated Values,” with many unwary investors reaching for them.


“A bubble is where investors buy an asset, not for its fundamental value, but because they plan to resell, at a higher price, to the next investor.”

                                               Peter Kugis-Stanford University


     Wall Street bubbles of over evaluation occur every few years for the same reason; people get greedy.

     There is a list of reasons people get greedy and cause the bubbles.

       We see an excessive amount of enthusiasm of big bubbles occurring after there has been great economic growth (railroads in the 1870s, cars and electricity in the 1920s and since 2000, internet/ technology). Bubbles create extreme amounts of enthusiasm, debt, corruption, hope, and speculation.

       This story presents highlights of bubbles in human nature and the reasons for their cause.

Stages of an Economic Bubble

     According to the economist Charles P. Kindleberger, the basic structure of a speculative bubble can be divided into 5 phases:

  • Substitution: increased value of an asset
  • Takeoff: speculative purchases (buy now/ sell high in the future for a profit)
  • Exuberance: a state of unsustainable euphoria.
  • Critical stage: begin to see fewer buyers; some begin to sell.
  • Pop (crash): prices plummet

Social Psychology of Bubbles

     GREATER FOOL THEORY states that bubbles are driven by the behavior of perennially optimistic market participants (the fools) who buy overvalued assets in anticipation of selling it to speculators (the greater fools) at a much higher price.    

       According to this explanation, the bubbles continue as long as fools can find greater fools to pay for the overvalued asset. The bubbles will end when the greater fool becomes the greatest fool who pays the top price for the overvalued asset and can no longer find another buyer to pay for it at a higher price.


       EXTRAPOLATION is projecting historical data into the future; if prices have risen at a certain rate in the past, they will continue to rise at that rate forever. The argument is that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to attempt to continue to capture those same rates of return.


     Another related explanation used in behavioral finance lies in herd behavior: investors tend to buy or sell in the direction of the market trend. This is sometimes helped by technical analysis that tries to precisely detect those trends and follow them, which creates a self-fulfilling prophecy.

Moral hazard

     Moral hazard is the prospect that a party who is insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.                                                (Source: Wikipedia)

Economic or asset price bubbles are often characterized by one or more of the following reasons:

     ● Unusual changes in single value measures, or relationships among measures (e.g., ratios) relative to their historical levels. For example, in the housing bubble of the 2000s, the housing prices were unusually high relative to income. For stocks, the price to earnings ratios were unusually high.

    ● High debe use (leverage) to purchase assets, such as purchasing stocks on margin or homes with a lower down payment. Higher risk lending and borrowing behavior, such as originating loans to borrowers with lower credit quality scores (e.g., subprime borrowers), combined with adjustable rate mortgages and “interest only” loans.

    ● Rationalizing borrowing, lending and purchase decisions based on expected future price increases rather than the ability of the borrower to repay.

     ● Rationalizing asset prices by thinking “this time it’s different” or “housing prices only go up.”

     ● A large amount of marketing or media coverage related to an asset class.

     ● International trade (current account) imbalances, resulting in an excess of savings over investments, increasing the volatility of capital flow among countries. For example, the flow of savings from Asia to the U.S. was one of the drivers of the 2000s housing bubble.

               ● A lower interest rate environment, which encourages lending and borrowing.  

                                                                   (Source: Wikipedia) 

Human Psychology of Economic Bubbles

      What’s really at the heart of financial bubbles is human behavior. There are four distinct psychological phases of financial bubbles. (see chart below)

Stealth Phase

      The stealth phase is the very early days of an asset when only a relatively few people are aware of it and can see the value… They are the true believers.

Awareness Phase

     Now big money comes calling. Institutional investors take an interest. There is some selloff during the awareness phase by the initial true believers but not enough for anyone to notice. …


Mania Phase

     The media notices what is going on and broadcasts it everywhere. Average investors catch wind that something big is happening and they want in. The price starts to rise, and inexperienced investors think it will keep going up forever.

Blow off Phase

     The blowoff phase is the bubble part. The selloff accelerates driven by fear. The fire sale plunges the price of the asset. There are now no greater fools. …”

               (Source: Candice Elliot of listenmoneymatter)


What Goes Around, Comes Around

Title: The millennium in Wall Street. (circa 1906 by W.A. Rogers). Summary: Sheep jumping off plank “elastic currency” over rhinoceros “the new finance” onto pillow of “unlimited credit.”

Modern Monetary Theory (MMT) is a current economic theory/scheme used by politicians who want to fund their pet programs.

This may be the ultimate economic theory used of fiat (paper) currencies with 0%, or less, interest rates we see today. This is a time when politicians don’t have to answer for their actions as they would if a gold standard were in place. Businessinsider.com

MMT is a big departure from conventional economic theory. It proposes that governments who control their own currency can spend freely, since they can always create more money to pay off debts.

Modern Monetary Theory suggests government spending can grow the economy to its full capacity, enrich the private sector, eliminate unemployment, and finance major programs such as universal healthcare, free college tuition, and green energy.

If spending generates a government deficit, this isn’t a problem. The government’s deficit is by definition the private sector’s surplus.

Increased government spending will not generate inflation as long as there is unused economic capacity or high unemployment.

MMT claims that it is only when an economy reaches physical or natural productivity constraints (such as full employment) that inflation occurs because that is when supplies fail to meet demand and prices rise.

MMT is known as “modern” but it is
not new. The idea of unlimited money
or credit has been around for centuries.

The Continental Congress used it when they needed cash to fund the Revolutionary War. They created the Continental Dollar, which was a zero-interest bearer bond. At the beginning, it was not paper (fiat) currency, but it essentially became a fiat currency when Congress changed the rules of redemption in ways that were not fiscally credible. Farley Grubb

What goes Around…

Economic theories aren’t the only things to come and go in a cycle. Interest rates also have their own cycle that rise and fall regardless of whether the world has fiat currency or a gold standard.
The chart below shows the interest rate cycle over the last 200+ years. There have been three complete cycles (from low to high and back to low) since 1800. In 2020, we are at the bottom of the cycle, waiting for the rising part of the cycle to begin its twenty-plus year rise.


The chart below shows the interest rate cycle over the last 200+ years. There have been three complete cycles (from low to high and back to low) since 1800. In 2020, we are at the bottom of the cycle, waiting for the rising part of the cycle to begin its twenty-plus year rise.

Below is from an online letter by financial writer Bill Bonner.
(Courtesy of Pfennig for your Thoughts,5/20/2020)

“No pure-paper money (aka fiat money) has ever survived a complete interest rate cycle.”
Now, (in 2020) we will see it put to the test. In the Panic of 1857, the yield on the U.S. 10-Year Treasury Note rose to 6.6%. It took a lifetime for it to reach the next top, in 1920. Then, another sixty-one years passed before we reached the next top.
In other words, these are generational trends. One generation learns. the next forgets. In a week, we can forget where we left the car keys. …Forty years later we can scarcely remember – or even imagine – the 15% mortgage rates of 1980. And what has happened to the “bond vigilantes” who used to sell U.S. Treasury bonds at the first sign of runaway deficits? Surely, they are in wheelchairs, unable to recall their own names, much less how they lost their fortunes betting against the bond bubble.
And if the pattern holds, in a few years, we’ll regret not having locked in today’s low mortgage rates… if we can remember them!
After this downdraft has flattened the economy, interest rates (and consumer price inflation) should begin to rise. In another 20 years or so, rates should be reaching for another generational top. Perhaps you’ll have to pay 15% for a mortgage. Or maybe it will be more like 50%. Or, mortgage lenders could be almost out of business, as they already are in Argentina. If you want to buy a house there, you’ll have to pay cash.

Relearning the Lesson

Yes, it’s back to school. Now, we learn – again – why, for 180 years, U.S. dollars were linked to gold, rather than simply to promises from the U.S. government.
In a nutshell, it’s because the 1791 generation (when the U.S. dollar first appeared) knew something the generation of 2020 has forgotten: Power corrupts.
And the power to create “money” is so irresistible that no race, no nation, no genius, and no government official has ever resisted it for long.
Eventually, a “necessity” arrives. Typically, it is a war or the threat of insurrection.
In the 1930s, Rudolf von Havenstein, was in charge of printing German money for the Weimar Republic. He said he had to do it to head off a Bolshevik Revolution. Instead, he got the Nazis.
And now, it’s Jerome Powell, Chairman of the Federal Reserve (or Rudolf von Powell) who is cranking hard on our own printing presses.”

…Comes Around

Today we are in a financial era with an historically unusual sequence of events and government policies that are not fiscally credible.
We have governments spending trillions of dollars they don’t have to help people survive the coronavirus pandemic, by issuing debt and printing electronic money they don’t have because they have a modern theory that allows them to do it.
• Economic theories work until they don’t.
• Rising interest rates lower the value of assets.