How To Spot A Financial Bubble

Rapid increases in asset prices are driven by universal factors.

- Johan Fourie

One of the most influential mathematicians of all time, Sir Isaac Newton, lost a fortune by investing in the South Sea Bubble of 1720. When asked why, with all his mathematical prowess, he could not foresee the collapse of the stock, he is reputed to have said that ‘he could not calculate the madness of the people’. And who can blame him for being unable to understand the seemingly irrational behaviour of hundreds or thousands or, sometimes, millions of people – the madness of crowds, as the journalist Charles Mackay coined the phrase in an 1841 bestseller on financial bubbles. Mackay’s nineteenth century interpretation for why bubbles occur is still how most of us would explain the spectacular and seemingly inexorable rise of asset prices during a bubble.

Think of the dotcom bubble of the early 2000s. Or the housing bubble that caused the Great Recession of 2008. Or, most recently, the bitcoin bubble. At the start of 2017, the price of bitcoin was below $1 000. By its end, it was $20 000 and there was wide speculation that it could go much higher because – and this is a frequent associate of bubble rhetoric – ‘this time is different’. It was not. Bitcoin lost 72% of its value the next year.