Perspective

Crises, Manias and Irrational ExuberanceFinancial Bubbles Throughout History: A Cautionary Tale

Executive Summary

A bubble is a period when the price of an asset irrationally exceeds the asset’s intrinsic value.

Investors’ behavioral tendencies, when collectively taken to excess, lead to bubbles.

The most common signs of bubbles are economic and financial, particularly extreme leverage.

Bubbles typically precede economic recessions, even if the bubbles do not necessarily cause the recessions.

Level-headed and disciplined planning can help investors to weather bubbles.

Page 1 | FINANCIAL BUBBLES THROUGHOUT HISTORY

In the financial world, a bubble is a period when the price of an asset—typically stocks, bonds or real estate—irrationally exceeds the asset’s intrinsic value. It is only a bubble, though, if it bursts and prices plummet, which may cause sellers to try frantically to get out.

The terms “financial bubble,” “asset bubble,” “economic bubble,” “market bubble” and “speculative bubble” are used interchangeably and often shortened to simply “bubble.” “Crisis” and “mania” are sometimes used as well.

Bubbles in HistoryLearning about bubbles’ long history is perhaps the best way to understand them. There have been no fewer than 80 economic crises globally since the first century, including 25 in the twentieth century and 26 already in the twenty-first. Moreover, 27 of the 80—or one-third—took place in the U.S. either exclusively or as part of a wider phenomenon.

South Sea bubble (1720)This was one of the first stock bubbles and the origin of the term “bubble”. It centered on the South Sea Company, to which the British government had promised a monopoly on trade with Spain’s South American colonies in exchange for the assumption of Britain’s massive war debts. South Sea shares soared more than 800% in 1720 on false rumors of the company’s huge success. Thousands of overextended investors across British society were ruined when the share price collapsed, causing a severe economic crisis.

Tulip Mania (1634–1637) Tulip Mania was one of the earliest recorded asset bubbles. In the sixteenth century, Westerners brought the tulip plant from the Ottoman Empire to Europe, where its then-rarity and exotic beauty attracted speculators from a wide cross-section of Dutch society in the 1630s. The price of a tulip bulb reportedly rocketed twenty-fold between November 1636 and February 1637, only to plunge 99% in three months. Fortunes were lost and the Dutch economy sank into a mild depression.

Railway Mania (1840s) Railway Mania was an economic and speculative bubble resulting from the introduction of modern railroads to Britain. Like the Internet bubble 150 years later, it was marked by investors’ insatiable appetite for a disruptive technology. Railroad stocks soared to dizzying heights and massive overbuilding took place: At one point, the money put into railway construction was more than double British military spending. When the bubble popped, many railroad companies went under, shareholders were devastated and outstanding debts were enormous.

Wall Street crash of 1929 Even today, nearly a century after it happened, the crash of 1929 remains the quintessential cautionary tale of a financial bubble. Many of the fundamental bubble characteristics that we describe later—excessive use of leverage to buy stocks, herd-like behavior, overconfidence and the mass popularity of speculation—were present and unstoppable.

Even though the “official” crash occurred on October 29, 1929 (the infamous “Black Tuesday”), prices continued to drop and finally bottomed three years later. The repercussions were widespread and devastating, with suicides, sky-high unemployment, millions thrown into poverty, and thousands of bank failures in the Great Depression.

BLACKTUESDAY

FINANCIAL BUBBLES THROUGHOUT HISTORY | Page 2

Where does the term ‘bubble’ come from?Used in a financial context, the term “bubble” dates back to the 1720 British South Sea bubble, in which executives of England’s South Sea Company greatly exaggerated the company’s business prospects to drive up the price of its shares. “Bubble” referred to the inflated shares of South Sea and the other companies involved: Their prices expanded based on nothing but air and were vulnerable to a sudden burst.

Japanese economic bubble (1980s)In response to a mid-1980s recession, the Japanese government undertook aggressive fiscal and monetary stimulus to turn the nation’s economy around. The plan worked too well: The subsequent economic boom resulted in Japanese stock prices and urban land values tripling between 1985 and the bubble’s peak in 1989. Japan’s economy deteriorated after that, as stocks and real estate slid and led the country into an agonizing period of deflation and stagnation (“stagflation”)—known as the lost decades—that lasted more than 20 years.

Stock market crash of 1987The bubble in U.S. stocks that inflated in 1986 burst wide open on October 19, 1987, when the Dow Jones Industrial Average fell 22.6%—still the biggest single-day percentage loss in U.S. history. “Black Monday,” as it is known, was the culmination of euphoric speculation fueled by hostile takeovers, insider trading, a flood of initial public offerings (IPOs) and newly popular leveraged buyouts funded by junk bonds.

But the nail in the coffin that day was portfolio insurance, an automated hedging strategy in which big institutions sold stock-index futures to soften the blow of falling prices. Portfolio insurance programs kicked in as the sell-off raged—resulting in yet more selling and exacerbating the decline. Unlike most bubbles, Black Monday did not feed a recession, as stocks recovered within weeks and resumed their upward climb.

Internet/dot.com bubble (late 1990s)The internet bubble—also known as the dot.com bubble or the tech bubble—was a classic case of mass market hysteria. The excitement of the then-nascent internet lured investors into the stocks of web-related names like Webvan, Pets.com, eToys.com and many others that had not even turned a profit yet. Valuations went through the roof amid declarations of a new status quo in which earnings did not matter. The tech-dominated NASDAQ Composite Index spiked to a new high in March 2000 and then dropped like a rock before bottoming in October 2002. As if on cue, a recession followed the peak.

BLACKMONDAY

U.S. housing bubble (2007–2009) The housing bubble was painful proof that investors have short memories. Even as the economy and financial markets emerged from the wreckage of the internet bubble, a new home-buying mania took shape. In retrospect, warning signs abounded: unsustainable consumer debt, rampant mortgage fraud, mounting defaults, willful ignorance of credit deterioration in mortgage-related securities—yet most investors looked the other way. The resulting global financial crisis was the worst economic contraction since the Great Depression, and the world continues to feel its effects today.

Page 3 | FINANCIAL BUBBLES THROUGHOUT HISTORY

A Consistent PatternBubbles tend to follow a pattern consisting of several stages. The economist Hyman Minsky identified five stages as part of his financial instability hypothesis (see chart below). While Minsky focused on the workings of credit cycles, his stages are equally applicable to bubbles.

Stage1 Displacement

This is when investors get excited about a new development they expect will dramatically change the world. In the late 1990s and early 2000s, for instance, the advent of the internet popularized the phrases “new paradigm” and “new economy” as shorthand for how information-based technology would transform both daily life and economic reality.

Stage2 Boom

Asset prices rise slowly and take on momentum as investors increasingly flock to the market. Speculation drives prices higher, which attracts more investors who do not want to miss out on the excitement—which attracts even more investors.

Stage3 Euphoria

Prices skyrocket and pull valuations with them, leading the market into dangerously vulnerable territory. Investors seize on new measures of valuation to justify soaring prices. In the dot.com bubble, “clicks” and “eyeballs” exemplified such measures as analysts sought new ways to value companies that, in many cases, were years away from generating profits.

Stage4 Profit taking/Crisis

The warning signs of froth are clear to investors willing to notice them, and they sell their positions accordingly. It’s worth noting that this is much easier said than done, however, as reflected in a quotation attributed to the economist and investor John Maynard Keynes:

Markets can remain irrational a lot longer than you and I can remain solvent.

— John Maynard Keynes

Stage5 Panic

The green light of investor sentiment turns bright red, and prices plummet as quickly as they had soared in stages 2 and 3. Sellers run for the exits and want to liquidate at any price. A great example of panic was the global sell-off in October 2008 on the heels of the Lehman Brothers bankruptcy and the near-collapse of giant financial intermediaries AIG, Fannie Mae and Freddie Mac.

As adapted by economic historian Charles Kindleberger.Source: Kindleberger, SG Cross Asset Research.

Minsky’s 5 Stages

Displacement

Boom

Euphoria

Crisis

Panic

Stage1

Stage2

Stage3

Stage4

Stage5

FINANCIAL BUBBLES THROUGHOUT HISTORY | Page 4

The Recession Connection There is another important pattern among bubbles: frequently, they are followed by economic recessions, even if the bubbles do not necessarily cause the recessions.

A recent study of bubbles in 17 nations spanning North America, Europe and Japan revealed that since World War II there have been 88 recessions, of which 62 (70%) were preceded by a bubble in equities, housing or both. The study broke down the 88 recessions further, into those associated with financial crises and those considered “normal” recessions:

u 21 of the 23 associated with financial crises, or 91%, followed a bubble.

u 41 of the 65 normal recessions, or 63%, followed a bubble.

Recessions after World War II

91% 63%

Financial crisis recessions preceded by bubbles

"Normal" recessions preceded by bubbles

Preceded by bubble Not preceded by bubble

Source: Òscar Jordà, Moritz Schularick and Alan M. Taylor, “Leveraged Bubbles,” National Bureau of Economic Research (NBER) Working Paper No. 21486, August 2015. Note: Recessions are the peaks of business cycles identified using the Bry and Boschan (1971) algorithm. A recession is labeled financial if there is a financial crisis within a two-year window of the peak. Otherwise it is labeled normal. Bubble episodes are associated with recessions by considering the expansion over which the bubble takes place and using the subsequent peak.

We Are Only Human—Which Can Be a ProblemEach bubble has its own specific circumstances and must be seen in the context of its time. Yet the ultimate cause of any bubble is timeless: human behavioral tendencies taken to excess. From the Dutch Tulip mania to the global financial crisis, it has been people’s emotionally driven buying and selling decisions—along with their fear of missing out—that have inflated bubbles and eventually burst them.

What are the tendencies that resulted in such decisions? Economists, psychologists and sociologists have identified a number of them:

Extrapolation is the projection of past trends into the future. If a stock has risen at a particular annualized rate in the past few years, we might assume that it will continue to do so going forward. If taken to extremes—as happens in bubbles—this could cause overbidding for stocks that have become very risky. It was not so long ago that millions of people kept buying homes based on the false premise that “home prices will always rise.”

Herding is the tendency to do what the crowd is doing because if so many people are doing it, it must be right—even when we know it does not make sense. We are afraid of missing out on what “everybody” is doing, so we just follow them down the rabbit hole. Tech stocks at the turn of the millennium or the pre-Black Monday IPO craze come to mind in this context.

The greater fool theory holds that we can safely buy a soaring asset because there will always be someone more foolish than us to whom we can sell it at a higher price. In bubbles, however, there’s always a greatest fool out there who ends up paying the top price and cannot find a buyer who will go higher.

Confirmation bias holds that we look for new information that confirms what we think and avoid information that contradicts it. The result is a one-sided view that causes investors to make poor decisions, whether in choosing investments or timing a purchase or sale.

Overconfidence in our own intuition can be a powerful driver of market activity. Too often, we make investment decisions by trusting our gut rather than weighing the hard evidence in front of us—in other words, we choose to ignore reality.

Wishful thinking is a bias in favor of things to which we feel an emotional attachment. It could be our favorite sports team, a lucky number or that crazy stock we have been riding up into the stratosphere.

“This time it is different” is an order of magnitude up from wishful thinking. We all want to believe that the past will not repeat itself because we are in a new environment in which the old status quo no longer applies. So we keep buying inflated stocks, gorging on high-yield bonds or mortgaging our first home to buy another one—until the bubble pops and we pay the inevitable price for our willful blindness.

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The Cycle of Investor Emotions It is natural to think we can avoid the tendencies that drive bubbles. But this thought just confirms that the tendencies exist—most prominently overconfidence, wishful thinking and “this time it’s different.”

The chart below illustrates the emotions we typically feel as our specific holdings or the broader market go through a bubble’s boom-and-bust cycle. Note that we feel euphoria (the same word used by Minsky to name his third stage of financial instability) at the top of the cycle, where it is actually riskiest to participate, and despondency at the bottom, where the biggest opportunities sit for the taking.

If we acted at the extreme points of the cycle based on our emotions, we would be throwing our money away. Better to heed the advice of Warren Buffett, who built his fortune by listening to his head instead of his heart. Buffett famously wrote during the depths of the global

financial crisis that, “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.” 1

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.

— Warren Buffett

By keeping Buffett’s words—and simple common sense—firmly in mind, we can sidestep the temptations of the bubble mentality. Why depend on the greater fool when we don’t have to be fools in the first place?

How to Spot a BubbleDespite how extreme bubbles can be, we cannot definitely identify one until it is over. What is more, a sustained period of overvaluation is not necessarily a bubble, as such periods usually end with corrections that bring prices down without flattening them.

What are the signs indicating that a bubble might be happening? Following are the those most frequently mentioned by economic historians and seasoned market watchers. Note that most of the signs are economic and financial, underscoring the critical role that non-market factors play in bubbles:

Unusually high use of credit to purchase assets

Buying stocks primarily on margin, making minimal down payments on homes and acquiring companies via highly leveraged buyouts are good examples.

Higher-risk lending and borrowing

Just think of the housing bubble, when mortgages with onerous terms were aggressively sold to borrowers with limited ability to pay the mortgages back.

1 “Buy American. I Am.” The New York Times, October 16, 2008.

Optimism

Excitement

Thrill

EuphoriaAnxiety

Denial

Fear

Depression

Panic

Capitulation

Despondency DepressionHope

ReliefOptimism

“Wow, I made a great investment.”

“Temporary setback.I’m a long-term investor.”

“Maybe the marketsjust aren’t for me.”

Point of maximumfinancial opportunity

Point of maximumfinancial risk

Hypothetical example shown for illustrative purposes only.

FINANCIAL BUBBLES THROUGHOUT HISTORY | Page 6

Low interest rates

In and of themselves, low interest rates are a sound way to encourage investment, whether in securities, capital equipment, research and development or corporate acquisitions. But low rates also can be dangerous if they stimulate speculative activity, excessive indebtedness and greater overall tolerance of risk.

Financial innovation

Big market participants are always looking for a financial edge. Two such innovations—futures-based portfolio insurance and credit default swaps—played major roles in the stock market crash of 1987 and the U.S. housing bubble, respectively.

International trade imbalances

When nations save more than they invest, they eventually want to put those savings where they think they will earn a good return. Sometimes that increases the volatility of capital flows among countries—as happened in the housing bubble, when flows from savings-heavy Asian nations poured into U.S. properties and helped to keep prices rising.

Heavy marketing or media coverage

If it seems like everyone is excited about a particular asset, chances are good that its upside either has peaked or is declining.

Amateur hour

The market may indeed be veering off its tracks when all kinds of people with little knowledge of investing are talking like experts, with off-the-charts conviction about the inevitability of higher prices.

How Can Investors Prepare? It is one thing to know about bubbles and understand what drives them and how they work, but quite another to manage a portfolio through them. There are a number of steps investors can take that are straightforward, time-tested and may be savvy in any market environment.

The first move happens well before any bubble signs appear. Investors should work with their financial advisor to develop a long-term investment plan that can endure through good times and bad—and stick to it. In addition, investors should aim to:

u Avoid emotional attachment to holdings and try to keep feelings out of the decision-making process.

u Maintain a well-diversified portfolio, which is the best defense against almost any market volatility or downturn.

u Rebalance portfolios on a consistent schedule—annually, semiannually or quarterly is widely recommended—to trim exposure to bubbly assets and add to others that may show greater promise.

u Stay away from excessive leverage, whether in the form of buying stocks on margin or external borrowing to fund asset purchases. Leverage only worsens the potential losses from a bubble.

u Avoid investments that are not fully understood. Many investors—both individuals and institutions—racked up big losses in the housing and internet bubbles because they bought complicated mortgage-related securities or stocks of companies with esoteric technologies.

If history teaches us anything, it is that bubbles will always recur. But by remembering that “This time, it is almost definitely not different,” investors can relearn this important lesson and focus on managing risk and protecting assets.

Contact your financial advisor to learn more about INVESTMENT ESSENTIALS or visit amgfunds.com/essentials for more information.

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Definitions:

Credit default swap—A swap is a derivative contract through which two parties exchange financial instruments (A derivative is a security with a price that is dependent upon or derived from one or more underlying assets.) A credit default swap is a particular type of swap designed to transfer the credit exposure of fixed income products between two or more parties.

Deflation—The general decline in prices for goods and services occurring when the inflation rate falls below 0%.

Initial public offering (IPO)—The very first sale of stock issued by a company to the public. Prior to an IPO the company is considered private, with a relatively small number of shareholders. Until a company’s stock is offered for sale to the public, the public is unable to invest in it.

Leveraged buyout—The acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.

Portfolio insurance—A hedging technique frequently used by institutional investors when market direction is uncertain or volatile.

Stagflation—A condition of slow economic growth and relatively high unemployment, or economic stagnation, accompanied by rising prices, or inflation.

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