You May Never Predict A Bubble, But There's No Reason Not To Try

Understanding the chemistry that fuels stock market bubbles is a difficult and complex study that even risk aversion professionals have a hard time grasping. So I wondered, is there any chance that we as first-time or even some of the seasoned retail investors can anticipate or predict, with even the most modest certainty, when and how these investment and asset bubbles will pop in the future?

I think the answer is no, not really. I do, however, believe that with just a little diligent effort in analysing the patterns of previous bubbles, perhaps we can at least avoid them. Let’s face it; bubbles not only exist and contributed almost first-handedly to the Great Recession and the financial crisis of 2008, but the phenomenon will continue and is almost guaranteed to happen again – maybe even sooner rather than later.

Let’s start by looking at some of the U.S. history’s biggest pops and use the knowledge and lessons learned in applying them to our hunt for today’s stock market or asset bubble.

Two bubbles for the price of one

Unquestionably, the most devastating, and perhaps until recently the most infamous stock market crash of all time came between the months of September and November of 1929, when the DOW nose-dived from roughly 380 to 200 points, cleaning slicing off about 50%.

But what’s “conveniently forgotten”, says Michael Bordo, Professor of Economics, and Director at the centre for Monetary and Financial History, Rutgers University, in a presentation called the CFR Symposium on a Second Look at the Great Depression and the New Deal is that over the next several months, from early November 1929 until sometime in the middle of April 1930, the Dow Jones average went up almost to 300 points again”.

That seems fine and dandy, until the newly created U.S. Federal Reserve decided to reel itself off the god standard while the rest of the public was still knee-deep in a love affair with the precious metal. The result, many scholars and economists who study the events will argue was a world-wide boom in demand and squeeze in supply for gold, bank illiquidity, and the Great Depression, during which the Dow Jones sank back down to 42 points by July of 1932.

One lesson I would like to take away from here is that before, during, and after the catastrophic financial events of the 30’s, gold has been widely considered a safe, hard asset to invest in during economic crisis.

The smartest bubble ever

What do the words, “” mean to you? As a first-time investor, you’re likely drawing a blank. As a seasoned retail investor in hindsight, that cute and naïve domain name could have served as the single most important lesson you’ve ever had the irritation of learning.

While the dot-com bubble’s bursting affects weren’t necessarily powerful enough to bring the entire economy to its knees, after hitting highs of around 5,000, more than double its valuation from just a year before, the technology-laced Nasdaq Composite index lost more than 60% and $5 trillion in the market value of the companies listed on the exchange between 2000 and 2003 as the tech bubble popped and deflated.

The lesson I would like to take away from the dot-com bubble is the reminder of the definition of a stock market bubble itself, which according to, is a “self-perpetuating rise or boom in the share prices of stocks of a particular industry.”

Absorbing the shock of the next pop
I think we can use these two valuable lesson and combine them to formulate our own personal “bubble preparedness plans” for our individual investment goals, and here’s how: identify where you think the next bubble could be forming, pick specific price points for getting in and out, and always be ready to let go.

Gold again is making big headlines all over print, media, and the Web, and for the same classic and recognisable reasons as those listed above: the price of the ubiquitous metal is hitting new highs (although inflation-adjusted, some will argue that gold actually hasn’t yet hit new highs, but that’s a whole other article).

We don’t have to look very far to identify the parallels between the historical crashed detailed above and the potential for a modern day gold bust. Panic ensued in the late 1920’s and early 1930’s as financial chaos set in to the economy, sparking a nasty recession, unemployment, and investor panic in the same fashion as the financial panic of 2008. The comparison is almost seamless.

Next, government officials, lawmakers, and the Fed’s from both eras’ poured billions of dollars into newly created laws that were designed to stimulate and kick-start growth in the economy. Both Feds also enacted fiscal monetary policies that included artificially low interest rates.

What happened next is again predictable for both eras’ as investors piled into the safe, hard asset that is gold, driving prices sky high among the worries and concerns of inflation, a weakened dollar and continued turmoil in the stock market.

Now let’s consider again the definition of a bubble as a self-perpetuating rise in asset prices. Fist, inflation isn’t really much of a concern – in fact, the Federal Open Market Committee has recently been talking about deflation becoming more of a concern than inflation, which if true, could be a fatal blow to gold prices.

Secondly, the dollar isn’t as weak as it once was going into the most recent crisis. Unpleasantly, the Euro was battered this year as Greece and a handful of other Euro-zone countries admitted the fiscal debt had become too much to bear, in some cases over 100% of GDP,  resulting in a massive bailout for the country and the strengthening of about 11% in the U.S. dollar against our overseas currency counterpart.

Lastly, turmoil in the stock market may have finally stabilised. It’s a bold claim, I know; but I’m making this prediction based on how far we have come since the beginning of the financial market fallout of 2008 and subsequent rally in March of 2009 to today. Despite some confidence-crushing stumbles like the FlashCrash of early May and continued volatility in all the major indices, September of 2010 has brought significant and solid gains almost across the board.

I don’t think we as first-time investor or even seasoned retail investors will ever be able predict or correctly identify and avoid stock market bubbles, but I do believe it’s never too early to start thinking about the next pop. After all, if I’m wrong, the only think I lose is some credibility or confidence in my investing abilities, which is probably good every now and then anyway. However, if I’m right, there’s no limit to how much I can win – or save.

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