There have always been economic booms and busts and, sooner or later, stock markets are bound to crash. The key question for investors is: what, if anything can you do about it? How can you build a portfolio to withstand a crash and minimise its impacts? And how can you avoid being swept along by the euphoria that tends to precede a crash?
ROBIN POWELL has been putting these questions to bubble expert JOHN TURNER, Professor of Finance and Financial History at Queen’s University Belfast. Professor Turner is the co-author, with William Quinn, of a new book, Boom and Bust: A Global History of Financial Bubbles. This is the second part of a two-part interview. If you missed the first, you can catch up here.
Are there any early signs that investors can keep an eye out for, to reduce the chance of getting caught up in one of these bubbles?
This is a question I’m very commonly asked: can we actually predict bubbles? I think one of the lessons that we draw out from the book is that it’s very difficult to predict bubbles in real time. It’s even hard to look back in time and definitively say that there was a bubble, and say what the causes of those were. So if it’s difficult with the benefit of hindsight, it’s super difficult in real time.
In the final chapter of the book, we try to draw out some lessons for investors. So we come back to what we call the three sides of the bubble triangle — speculation, marketability and easy money. If those three things are prevalent, it doesn’t necessarily mean that there’s a bubble, but you should be alert to the possibility that there’s going to be a bubble because the necessary conditions have been met.
But bubbles are ultimately caused by these sparks, and often sparks are related to new technology. It’s really difficult to know where new technology is going to come from or, if a new technology is developed, if it’s going to be widely adopted, if it’s going to be successful. So, back in the 1990s, who knew that the internet was going to be such a wonderful thing? Who could really foresee that? You could take a punt and say “It’s probably going to do OK”, but we didn’t know for sure.
Then, with government policy, it’s very hard to predict what the spark from government policy will be. It’s hard to predict the future. So I suppose our advice to investors is: if they want to try and figure out if there is a spark out there, then they need to spend a lot of time and they need to develop what we call new mental models. They need to think about how the economy’s functioning, how the financial markets are functioning, but also the psychology of investors and sociology. They also need to trying to understand developments in technology. But I think our main piece of advice to investors is: don’t get caught up in bubbles. Sit them out.
That strategy certainly paid off last year. Markets crashed in March 2020 but by August they had more or less recovered.
What happened last year a really interesting point because we can think of March 2020 in one of two ways. Firstly, there was an overreaction. So investors panicked and rushed for the exits, and that drove down down the asset prices. That’s one way of thinking about it. But the way I think about it is that central banks around the world stepped in. Central banks around the world are underwriting the market and particularly in the US, where you had a President who was obsessed with the stock market and how the stock market was doing. It was that underwriting of the market by the central banks that stopped the market falling and encouraged the initial rebound that we saw. I think other things have taken over since then, but if investors know that the central banks or governments are going to step in and stop the market falling, how does that change the behaviour of investors? Do they take more risks, because they think that the central bank is just going to stop the market from crashing? Do we assume that there’s going to be a Greenspan to protects us? That actually creates concerns for me, moving forward.
As well as general crashes, there are crashes that impact on specific sectors — the bursting of the dotcom bubble, for example.
I think that is an important distinction, but also an important distinction in terms of what is the spark of the bubble. So with both the 1990s tech bubble and bicycle stocks in the nineteenth century, it was new technology that provided the spark. The boom happens in the new technology part of the market, and it doesn’t happen elsewhere in the market. So, when the new technology part crashes, there isn’t the same spillover effect into the general economy because of that. That kind of partially explains why that happened.
This has happened time and again in history — a new technology emerges, and proves hugely successful, and yet the benefits accrue mainly to consumers rather than investors.
It’s a really interesting point that you make there, that it’s the general public that benefit more than the investors. You tend to observe this with some of these technological bubbles, that they’re actually good for society, and we could call them “useful bubbles” in that regard. But then investors, or the vast majority of investors, actually lose out. One way of thinking of these technology stocks is that there’s lots of them that actually come to the market: lots of them fail, but there’s one or two that do really well. For example, had you invested in Amazon’s IPO back in the 1990s and you held that stock today, you’d be a very wealthy individual. But, had you invested in 20 other stocks, you probably would have lost all your money. So there is that lottery element to some of these technology companies, and we don’t know which ones are going to succeed. It was the same with the bicycle stocks. There were more than 600 bicycle companies, and who knew that Raleigh was going to come out on top? Many of the others failed, and investors would have lost their money.
Some of the best-performing funds last year in the US were green technology funds. So, again, people are seeing the future, they’re seeing the way government policy is moving, and who knows how many of the companies in that fund will actually still be around in ten years’ time and produced a return for investors.
So do you think we could see a crash in ESG stocks?
Potentially. Again, it could be coming from the spark of government policy, because governments around the world have been really pushing the move to net zero. Therefore, companies are falling in line behind that and, yes, potentially, we could be looking at a bubble in these types of stocks. Tesla is a prime example of a stock that has benefited from this push for green technology. But it worries me that this push might also be driving a bubble in Tesla stocks and in other stocks that are working in the whole area of green technology.
Amongst a lot of the amateur millennial investors, there’s a cult-like aura around Elon Musk, So when he says Tesla’s going to invest some of its cash in bitcoin, people get really excited about that. They see him as an outsider, so he’s like the Pied Piper of Hamelin attracting a lot of the young millennial investors behind him. That worries me as well.
What did you make of the GameStop saga?
GameStop was super interesting because, taking the historical perspective, we have seen short squeezes in the past. But it typically hasn’t been a bunch of amateur investors colluding together; it’s typically the insiders within a firm, whether that be large shareholders or directors. In other words, their stock is being shorted, so they try and corner the market and squeeze the short seller. We saw some really good examples during the bicycle-mania that actually ended up going to court.
With GameStop we’ve got another short squeeze, except now it’s being coordinated by social media. I would want to wait a few months to see who has won and lost, because there are a lot of amateur investors coming in and putting the squeeze on the hedge funds who were shorting GameStop and other types of stocks. But you have to be concerned that there was a lot of market manipulation going on. Until we have that investigation, it’s going to be difficult to really know who the winners and losers are, and whether we’re going to see that type of thing happen again.
If predicting a crash is as difficult as you say it is, what does that mean for portfolio construction and investment strategy? Should investors just block out the noise and stay invested?
For most investors, I would say that is what they should do. One of the several lessons of stock market history for me is that it’s really difficult to time markets. Trying to sell at the to and buy at the bottom — history tells me that’s really difficult to do.
But history also tells me that if you’re holding a balanced portfolio, you’re going to earn a premium over government bonds that, depending on the economy you’re in, is going to be of the order of four-to-six per cent per annum. Elroy Dimson and his colleagues have produced wonderful returns series for economies across the world back to 1900 that shows us the equity risk premium. If you compound that over time, 30 years or more, you’re going to be doing OK.
The third lesson of history, I think, for the everyday investor, is to be aware of inflation because inflation can come along and hit investors with nasty surprises. It’s a long time since we, in Western democracies, have witnessed high inflation. But look at the high inflation of the 1970s. What did that do to fixed income? It really hurt fixed income investors. During the First World War, we had four years of inflation close to 15%. What did that do to fixed income investors? It really hurt them. So if you’re holding lots of cash, or lots of government bonds, you need to take into account that inflation can happen and can really quickly erode the value of your holding.
Yet investors need a defensive component to their portfolio, and bonds, particularly government bonds, have a role to play in that respect.
Yes, bonds could be part of that defensive element of your portfolio. Short-dated Treasurys would be preferable. There are a couple of issues with corporate bonds. Particularly in the UK, historically we’ve had a very small market in corporate bonds, relative to other countries. You would also have to be worried about the liquidity of a corporate bond market because of that, and then there’s the credit risk associated with corporate bonds as well as that inflation risk.
Investors should have a well-diversified portfolio across different sectors and different classes. And dividends still have an important role to play, so reinvesting your dividend income is also super important.
Finally, of all the bubbles you’ve looked at, do you have an overlooked favourite?
Yes I do, and that’s a bubble that took place in Australia in the 1880s. It was probably the first major bubble that had devastating economic consequences for an economy. So in the 1880s, Melbourne and other parts of Australia went through this huge property boom that also spilled over into the stock market because a lot of the property development companies and banks got involved in funding this bubble.
The government were also involved, because they were deregulating the financial system. So Australia had an almost completely deregulated financial system, no central bank and, in essence, no regulation of banks. It was a great party while it lasted, but then it burst and it had devastating consequences. Half of Australia’s banks at the time failed. Australia entered a deep depression and it took them two decades to recover from the economic fallout of that bubble.
The fact that it happened in an era and in a country where there was no central bank, and where the banking system was deregulated, kind of makes it fascinating for me.
The original interview with Professor Turner has been slightly edited for brevity and clarity.
Boom and Bust: A Global History of Financial Bubbles by William Quinn and John D. Turner is published by Cambridge University Press. You can find more information on it here.
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