The Difference Between a Bubble and a Cycle
1. Brace yourself
According to various media sources we now have at least 14 Bubbles -
A new Real Estate Bubble.
A Bond Bubble.
A Tech Bubble.
A VC Bubble.
A Startup Bubble.
A Stock Bubble.
A Social Media Bubble.
A Solar Panel Bubble.
A SPAC Bubble.
A Crypto Bubble.
A College Tuition Bubble.
A Canadian Housing Bubble.
A Central Bank Bubble.
A China Bubble.
One economist recently gave up and just said “Everything’s a Bubble.”
2. How did that happen?
Yale economist Robert Shiller has said something amazing - The word “bubble” wasn’t even in the economic lexicon 25 years ago. Not in textbooks, not in papers, not in schools. But now we have bubbles everywhere.
How did that happen?
The good news is, I don’t think it did happen.
Markets have been rising and falling for centuries, but the term “bubble” is new. Since it’s new, there’s no official definition of what it is. Since there’s no definition, anyone can classify anything they want as a bubble and no one can prove them wrong. What began as a serious topic among economists has become a job-security loophole for pundits.
3. Cycles
In my experience, most of what people call a bubble turns out to be something far less sinister - A regular cycle of capitalism.
Cycles are one of the most fundamental and normal parts of how markets work. They look like this -
- Prices Fall
- Something offers a big return
- People Rush in to exploit opportunity
- Prices are bid up
- Return prospects fall
- Low returns scare people away
- Prices Fall
This cycle is self-reinforcing, because if assets didn’t get expensive they’d offer big returns, and offering big returns attracts capital, which makes them expensive. That’s why cycles are everywhere and we can never get rid of them.
4. Bubbles
To me a bubble is when this cycle breaks. It’s only a Bubble if return prospects don’t improve after prices fall. It’s when an asset class offers you no hope of recovery, ever. This only happens when the the entire premise of an investment goes up in smoke.
That was true of a lot of dot-com stocks, which weren’t bargains after they fell 90% because there was still no tangible company backing them up. It was true of homes in the mid-2000s, because you stood no chance of enjoying a recovery if you were foreclosed on. It was true of Holland’s 1600s tulip bubble, as the entire idea that tulips had any value went up in smoke.
But it wasn’t true of stocks in 2007. Yes, the market fell 50%. But that made it so cheap – particularly compared to the alternative of bonds – that buyers instantly came rushing back in. Prices hit a new all-time high by 2013.
5. Conclusion
Bubbles should be avoided, because you risk widespread permanent loss of capital. Cycles, by and large, shouldn’t, because all they imply is that you have to be patient and humble to earn long-term returns, which is par for the course for successful investing.
The investing world becomes a lot less scary when you view most booms and busts as cycles rather than bubbles. Will things ebb and flow, sometimes by a lot? Well, yeah. That’s what you signed up for as an investor. But is everything with a valuation above its historic average a civilisation-shattering bubble? Not by a long shot.
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