History repeats Itself: Could there be yet another bubble inflating?
The South Sea Bubble of the 1720s and the stock market turbulence of the 2020s, what's the difference between them?
At first glance, a lot of things. The 300-year period between the two events has inevitably brought technological advances and better economic understanding. However, looking beyond the surface, these two periods seemingly have many similarities.
In the 1720s, Britain’s agriculturally based economy had been through the ravages of war and was subsequently riddled with government debt. New investors coming into the market were bullishly snatching up South Sea Company Shares, causing prices to increase 10-fold. With asset prices hugely exceeding their intrinsic value, a rapidly inflating bubble was seemingly on the horizon. However, the remarks hindsight so accurately drew seemingly came around far too late - the bubble burst - and many suffered.
Today, the COVID-19 pandemic has ravaged economies across the globe. A myriad of stimulus packages and millions of jobless claims have once again riddled nations with mountains of debt. Despite the uncertainty, US growth stocks, including Tesla and Airbnb, have been booming. Understandably, JPMorgan considers these firms to be “dramatically overvalued”, as Tesla’s share prices have surged a near 800% in the last two years. In addition, the S&P 500’s price to earnings ratio, is nearing its highest level in almost two decades. Therefore, arguably people should not ask whether there is a bubble, but rather when the bubble burst?
However, just like all the challenges that have defined 2020, the question regarding the existence of a bubble is tricky. Therefore it is crucial to understand how economists define a bubble in order to make sense of these complexities.
A bubble is an economic cycle, symbolised by prices rising significantly above the asset’s intrinsic value. Although appearing straightforward, there is not a universally accepted theory explaining the formation of bubbles. Classical-liberal economists mostly blame central banks, such as the Federal Reserve and Bank of England, for fuelling excessive investment by pumping too much money into the economy. The Keynesian view, however, puts human emotion or ‘animal spirits’ at fault. It believes that the herd mentality of ignorant investors is the overarching factor driving up stock prices. Whether it be easy-money or exuberant market behaviour, once triggered, bubbles tend to have the same five stages as identified by Hyman Minsky.
First, the ‘displacement’ stage, characterised by investors noticing a new paradigm. In the 1720s this was the South Sea Company buying up government debt and gaining monopoly status. In 2020, the paradigm shift could be seen as the abundance of ‘cheap money’ due to low-interest rates or the change in consumer preferences COVID-19 has accelerated towards eCommerce.
Second, Minsky’s ‘boom’ stage, exemplified by the decupling of share prices during the South Sea bubble and, credibly, the obscene amount of capital flowing into US growth stocks today. These rapid price increases are the manifestation of investors’ ‘animal spirits’, as no investor wants to miss out on the chance of making a return. ‘Euphoria’ occurs next, Minsky’s third stage where asset prices peak, and irrational behaviour pervades.
The bubble bursts. Investors once scared of missing out often end up losing out. The lucky, or smart, ones may make money if they successfully identify the early warning signs. However, those that miss out on the ‘profit-taking’ stage and end up holding onto their assets until the ‘panic’ stage are largely wiped of their profits.
Isaac Newton’s losses in the South Sea bubble highlight that the intelligent ones don’t always win. Bubbles are shrewd and hidden. Today, a stock market bubble may be disguised, or as argued by the Financial Times, the markets may be well priced.
A recent FT article notes that as long as corporate earnings remain strong and interest rates low, stock prices are reasonably priced. Interest rates are indeed meagre, currently at 0.1% in the UK. However, the prospects for corporate earnings do not paint such a clear picture. Forward-thinking firms, such as Netflix and Zoom, have been able to reap some of the only benefits brought about by COVID-19. As lockdowns spread and people are forced to stay at home, workers spoke with colleagues and attended meetings through zoom calls and finished their day off with marathons of ‘Suits’. These changing consumer habits have been reflected in the S&P 500, where 55% of its recent increases are attributed to gains in the information and technology sector.
Ultra-low interest rates, making bonds unattractive, provide another explanation to the surge in stock market participation. In addition, new user-friendly trading and investment platforms, such as Robinhood, have aided this expansion in participation. In the first quarter of 2020, Robinhood added three million accounts. Lockdowns and an influx of cash from direct government stimulus payments likely also played a role in catalysing this sudden jump in retail investing.
Investors need to be wary. If interest rates rise, stock prices may become considerably overvalued, especially if the savings rate falls—a very conceivable reality considering the ageing populations of the US and UK.
The question surrounding the current stock market bubble persists. The virtues of hindsight as always will come around too late. However, if there is an inflating bubble among us, it may be capitalism’s way of metamorphosing the economy. Without the Internet bubble, perhaps AOL’s improvements in internet connectivity may not have brought prosperity to millions of people in isolated regions. Conceivably, therefore, increased investments in stock such as Tesla may hasten the shift to renewable energies. A move that cannot come soon enough.
This is not to say that a bubble will not ravage the economy. The 1720s validates this. We can, however, hope that savings are not entirely wiped and that the impact is not widespread. Newton may not have spotted the South Sea bubble, but he was no Einstein.