How Are Bubbles Formed?

January 8, 2018

I’ve always thought of a bubble as a compounded result of residual greed when the optimism of the many are perpetually validated.

This reminds me of what Warren Buffett tells us to do when we see compelling evidence of an impending bubble:

“Be fearful when others are greedy, and greedy when others are fearful.” – Warren Buffett

But only a few have the discipline to do this, because everyone can easily forget about the principle when they’re constantly seduced by social proofs of getting rich by everyone they know, everywhere they look.

I can think of three examples of bubbles to illustrate what I mean by compounded greed due to reinforced optimism: the stock market, real estate, and manufacturing.

Stock Market Bubble

A stock market bubble starts when investors become optimistic above moderate levels for a company’s future performance. This creates a buying avalanche for the company’s shares and raises the stock price along with the company’s valuation. Because the stock keeps going “green” as the company continues to achieve positive expectations quarter over quarter, it attracts even more people to be on boardAnd here people have already forgotten the principle that they should be buying low, not buying high! .

In other words, as quarterly reports come and the company keeps on beating estimates, this results into compounded vicious cycles of investment euphoria where people expect more and more from the company’s near-term performance. Sooner or later, this becomes unsustainable and expectations end up severely misaligned and unrealistic in relation to how much more the company can grow and how much bigger it hopes its captured, perhaps then saturated, market will still increase in size.

A threshold is suddenly reached when the company, to the best of its ability, cannot meet such investor expectationsFor example, the promise of “2x growth every quarter” which is not uncommon these days and everyone sells in panic causing sharp downturns in the company’s valuation. Pop goes the bubble.

Housing Bubble

A housing bubble starts when the market, house buyers that is, starts tolerating what will eventually become a bullish streak of housing price increases. To note, an increase in housing prices can be caused by inflation, interest rates, or simply greater demand for real estate.

An increase in housing prices translates to more profit for real estate suppliers, which in turn provides them with additional capital to build even more houses. Going back to our definition of a bubble, real estate providers are self-encouraged to build more houses due to an overly optimistic outlook of housing sales that keeps on getting vindicated.

After continuous building, there comes a point when the supply becomes greater than the demand, but a lingering sense of optimism persists among suppliers due to their “winning streak” which widens the supply-demand gap even further along with the hopes that the buyers can keep tolerating high prices. The supply-demand gap can end up being dramatically improportionate if, in the first place, what was thought to be actual demand was nothing but perceived demand.

There comes a threshold when buyers stop tolerating sky-high prices while having more options to choose from due to an increase in supply, effecting in suppliers scrambling for sales and competing by lowering their prices. Pop goes the bubble.For the disciplined and patient, this is the ideal time to buy a house, not when the market is “hot” and all their peers are buying. Talk about peer-pressure!

Manufacturing Bubble

Similar to the housing bubble, a manufacturing bubble starts when suppliers outperform, in a continuous fashion, their near-term positive outlook for product sales. Due to perpetually validated optimism, their greed and excitement leads them to spend more capital and push production even further which in turn causes oversupply.

Now time moves forward and excess supply becomes “out of fashion” as new, revised products get released into the market, alongside friction from competitor’s products, and perhaps when people have gotten over the hype of a new product category that was introduced into the market. Suppliers are then forced to sell products at a discounted rate to gain back some of the capital invested to manufacture them. This causes a decrease in the return of investment.

“History always repeats itself for those who haven’t learned or are yet to learn from it.” – Anonymous

Bubbles are an an inevitable part of history. Time and time again, having forgotten prudence, people have been tempted into executing ambitious plans based on optimistic projections of tomorrow. The best we can do is to learn from history, or, for the stubborn, shoot ourselves on the foot playing into and being a catalyst of a bubble.

How Are Bubbles Formed? - January 8, 2018 - Adler Santos