The history of asset bubbles is a fascinating one. From the Tulip Bulb Mania of the 17th Century, the Mississippi Company speculative blowout of the 18th Century, the American Railroad Stock bubble of the 19th century, the "go-go" American Stock market episode of the 1960s, and the Tech Stock speculative episode in very recent times asset class over-valuation periods are permanent feature in freely traded markets. What connects all of the these disparate historic episodes is the universal effect of the credit cycle as on the perceptions of risk and reward seen in different investment opportunities.
The credit cycle, mediated through the banking system, exercises the predominant influence on the development of investment manias and bubbles. During the initial phase of the credit cycle bankers exercise a great deal of caution because the macro-economy is in a state of downturn or recession. During this phase, bankers will only write loans or issue corporate securities for borrowers who can pledge solid collateral and whose cash flow can comfortably cover loan payments, bond interest payments or dividend payments.
During the next phase of the credit cycle the macro-economy will have entered a recovery phase and credit standards start to loosen. Under competitive pressures bankers begin to consider borrowers with weaker balance sheets and spottier cash flow track records. The greater strength of the macro-economy during this phase makes such companies seem less risky and underwriting these loans is more profitable. Rising asset prices during this phase make it harder to assess the greater risk of inherent in writing loans for this less credit-worthy class of borrowers.
During the next phase of the credit cycle the macro-economy enters a full-utilization period and asset prices continue to rise. During this phase "animal spirits" reach a fever pitch and risk sensitivity almost disappears. It is also during this phase that credit is made available borrowers with no collateral and no cash flow. In an environment of seemingly endless asset price appreciation such loans can seem to make sense. Everyone is seeming to make money even the cab driver in the stock market. Typically during this phase an "investment theme" will emerge that seems to justify asset prices. Such thinking was seen recently in the so-called Tech Stock Bubble.
Invariably some external shock will intervene which will serve to deflate the asset bubble. In the case of the Tech Stock Bubble the financial accounting scandals at Worldcom and Enron forced everyone to re-evaluate the economic fundamentals and confront deteriorating economic conditions. During this final phase of the credit cycle asset prices enter into a general price deflation and available credit becomes scarce as lending standards are re-evaluated in light of new conditions. It is during this phase that assets will be sold for pennies on the dollar versus the prices seen during the more exuberant boom phase.
Identifying whether one is in an asset bubble is difficult but not impossible. It requires contrary thinking and an ability to monitor certain qualitative and quantitative indicators. On the quantitative side, an asset price graph that resembles an exponential function graph is indicator of a market that has come unhooked from economic fundamentals. On the qualitative side, an asset class in the midst of a valuation will be attached to a "story" that seems to justify ever and ever higher prices. Chinese Stocks seem to satisfy these criteria at the present time.
As long as we have freely trade markets and a private banking system we will continue to see the emergence and deflation of asset bubbles. Opportunistic investors can make fortunes from this state of affairs provided that you can manage your cash and that you "can keep your head while everyone else is losing theirs....".