How to spot a financial bubble – With insights from The Wall Street Journal

Use Spotify? Access BizNews podcasts here..Use Apple Podcasts? Access BizNews podcasts here..___STEADY_PAYWALL___.From Dutch Tulips to Internet Stocks, How to Spot a Financial Bubble.Long before SPACs and NFTs, investors clamoured for everything from exotic bulbs to Pets.com. What history shows is that an inventive corner of the financial world can turn into a mania that attracts swindlers and wipes out investors..By Jon Hilsenrath of The Wall Street Journal.Updated May 7, 2021 2:01 pm ET.About 300 years ago, financiers in Europe found themselves agog about the financial prospects of novel trading companies granted special rights in international commerce by the governments of France and England. The shares of these trading vehicles—England's South Sea Company and France's Mississippi Company—soared and then collapsed in 1720, wiping out hordes of angry investors..Episodes like that have some economic historians wrinkling their brows about what is happening in financial markets today, with Wall Street once again in the embrace of perplexing crazes for new investment vehicles..The price of bitcoin, the cryptocurrency, has risen more than sixfold in the past year. Meantime, shell companies called special-purpose acquisition companies—also known as SPACs, which list on a stock exchange and then buy target companies—have raised more than $100 billion this year, according to Dealogic. Investors are also clamoring for nonfungible tokens, digital certificates to online collector's items, like art or autographs.Do these instruments signal a bright new world in finance, or something else?History shows that investment crazes are often associated with financial innovation, new instruments created by Wall Street middlemen, surrounded by mystery and fueled by expectations of big future profits.Sometimes they go very badly.Intimately connected with the 2008-2009 financial crisis that nearly took down the entire U.S. financial system was a boom in collateralized debt obligations (bundles of risky mortgages) and credit default swaps (insurance deals on risky mortgages.) Before that, there were profitless internet companies in the 1990s that listed themselves publicly at immense valuations. Many of them flamed out before earning a penny.Before the trading companies of the 1700s—which peddled in slavery, among other things—there were exotic Dutch tulip bulbs in 1636 and 1637, prized for their variety and capacity to regrow. According to a history by Charles Mackay, "Extraordinary Popular Delusions and the Madness of Crowds," one Viceroy bulb during that episode was worth two bundles of wheat, four bundles of rye, four oxen, eight swine, 12 sheep, two hogsheads of wine, beer, butter, cheese, a bed, a suit and a silver drinking cup.Charles Kindleberger, the late MIT professor who wrote the popular book, "Manias, Panics and Crashes," called such speculation and crisis a hardy perennial."Periods of great innovation are interesting from an investor's perspective because you can justify a wide range of valuations," says Robin Greenwood, a Harvard Business School professor who has studied bubbles. He says another classic example was a 1920s boom in closed-end funds, investment portfolios that trade on an exchange. Before the 1929 stock crash, issuance of closed-end funds soared and the prices on the funds raced ahead of the underlying values of their investment holdings.Swindlers are oftentimes attached to the financial boom, too. That included Robert Knight, who helped cook the books of the South Sea Company, fled England and landed in an Antwerp prison for a time. Then there was Bernie Madoff, who cooked up his own investment Ponzi scheme that crashed in December 2008. He died in jail last month.Mr. Greenwood notes that oftentimes the financial innovation itself might survive the bubble and crash, as was the case for the concept of closed-end mutual funds in the 1920s and internet stocks in the 1990s.While odd-looking booms in new instruments can be a sign that something is going awry in markets, he said that is not always the case."A lot of things that look like bubbles are not," he said. Technology stocks soared in the early 1990s, he noted. That actually presaged nearly a decade of prosperity. The uncertainty is one of the factors that make bubbles possible. It is often plausible to argue against the notion that there is a bubble until it is too late."Making calls about a bubble at the aggregate market level is a fool's errand," Mr. Greenwood said. "I'm very interested in that question, but I have not succeeded and I've worked at this for a while."Willem Buiter, a visiting professor at Columbia University and another bubble historian, said innovation is itself a perennial of Wall Street. It is constantly happening, during normal times and other times. What stands out about financial innovation during bubbles is that new instruments become devices for speculation and excess. The innovation itself might not be the problem. The problem might be when investment in the vehicle is fuelled by a surge in borrowing."Leverage is the killer," Mr. Buiter said.That was certainly the case for the 2000s, when collateralised debt obligations helped fuel mortgage borrowing. Between 2000 and 2008, debt in the financial sector more than doubled from $8.7 trillion to $18 trillion; among households it doubled from $7.2 trillion to $14.1 trillion, according to Federal Reserve data.This time the pattern is different. Though government debt is rising fast, debt in the financial sector remains below its 2008 peak and household debt has been rising more slowly than in the 2000s. Between 2012 and 2020, household debt rose to $16.6 trillion, from $13.6 trillion. That is something that gives Mr. Buiter some peace of mind."There are signs, indicators of excess, but they haven't led us down the path of an unsustainable credit boom yet," Mr. Buiter said.Write to Jon Hilsenrath at jon.hilsenrath@wsj.comCopyright ©2020 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8Appeared in the May 8, 2021, print edition as 'How to Spot a Bubble: A Field Guide.'

How to spot a financial bubble – With insights from The Wall Street Journal

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