THE CLOCKWORK INVESTOR 11 – Basic mechanics of financial bubbles (part 1)


By Francesco Caruso, MFTA, Global Asset Strategy Amber SICAV advisor

Bubbles: how they are formed and what creates them

Bubbles are bullish movements, in the sense that bubbles mean a swelling of quotations up to exaggerated levels, followed by a deflating (violent fall) under the burden of returning to reality. This is what technically happens when you have a financial bubble. Why it happens is something more complex. A bubble occurs, paradoxically, because of the lack of operator’s conviction about a certain movement in progress. In a bubble, the total conviction of operators arrives at the terminal stage, after some kind of obstructionism of the mind that a market / title / sector / commodity or otherwise is rising.
I’ll try to explain each axiom with examples. The first is the bubble that broke out in 2000 (Nasdaq). It was not a movement that suddenly arose; on the contrary, it came after a long hesitant rise, where everyone said that the Nasdaq was overvalued, that it could not be so high and that sooner or later it would have dropped …. If you say that a rising title is about to go down, it means that you have two possible positions: either you do not have it (or maybe you have very few and still less than what you should have if you were an asset manager) or even – if you are a trader – that you’re bearish. Another way of being bearish is the uncovered sell of the call options, which practically are purchase rights.
All the operators who in a rising market have this type of placement, have only one chance to close their positions and stop losing: buy.
The paradox is that all those who fight the trend at a bullish stage, unfortunately become the gas to the fire of the bullish stage itself.

What happened with the Nasdaq? It happened that they were all out of market because they thought it was too expensive, the Nasdaq instead of correcting ripped upwards, the customers and top managers got angry because their asset managers were not doing well, and all these people had to act forcibly coming back (or better, chasing) with the result of pushing themselves into the bubble.

Lack of conviction and incorrect positioning during a trend are the key to creating a bubble or a crash. Fundamentals have no weight in the ending part.

What is behind the lack of conviction, the unwillingness to see things for what they are or the lack of skills?

Mostly there is an excess of rationalization. What usually a manager does, which an investor should do too, is to buy assets that have an intrinsic value and a low value compared to the average. If there is no objective value or the price at that time is high, the only human motivation to buy is that you hope to resell to someone else at a higher price. The Americans say that “you’re hoping for a greater fool”, that is someone crazier than you. It is the concept of trend following. But in the end, on the top, somebody stays with the famous Peppa Tencia in hand (Peppa Tencia is the Italian variation of card game known as Hearts, in this game the “Peppa” is the losing card and the aim of the play is to pass it to the other players before the game ends), while all those who have given up the “Peppa” through the game know that they have to stay out, therefore they are relatively quiet.

What does it take to stay with Peppa Tencia in hand or rather how do you get out of the game in time?

This is a complex subject that has to do with behavioral patterns, technical patterns, and so on. An asset that enters the bubble, in the uphill phase is often underweighted in the investors’ portfolios, and only when it enters the final stage of the ascent it becomes overly overweighted.

Example: the scary stock bubble of 2000. Back then, the MIB index was worth 50,000 and today, after 17 years, it is still between 20,000 and 22,000. Many European markets have not yet been able to recover the levels of 2000. In February of that year (2000), the month before the bubble burst, I was called to make a conference at the Palazzo delle Stelline in Milan, with a forecast of 50/80 people.
When I arrived, they warned me that there were 5000 people waiting to be connected by 7 outdoor rooms because there was no room big enough to contain them all.
At the end of my presentation, I was more curious about them than they did to me and I encouraged them to ask questions about what they had in the portfolio. Everyone had questions about two recents IPO, Seat and Tiscali. So, I asked: “How many of you have Seat and Tiscali’s in portfolio”? Almost all hands raised, a good 80+%. I looked at them and once again asked: “In your opinion, after this titles have multiplied upward in recent months seemingly without a reason, who will push them up if you already have them in the portfolio?”
There was a moment of silence.
On March 6, 2000, Seat and Tiscali began a tremendous collapse, Seat was delisted and Tiscali is still a fraction of what was worth it in those days.

Can bubbles be understood?

Historical bubbles, such as the tulip bubble in 1600 and others over the centuries, have been studied long and wide, not least that of 1929, which was widely dealt with by Nobel Prize Robert Shiller in a beautiful book that I highly recommend to you all: Irrational Exuberance, great reading for anyone.
The evolution of a bubble is quite simple: in a market, there is a kind of aversion to a rising movement, which is not totally understood or believed.
Example: gold quotation between 2001 and 2011. In 2001, it was $ 250 an ounce and central banks sold it because according to a study they published it had to reach $ 80. I published an article on Sole24Ore, followed by others that can still be found on my blog (under the Scripta Manent section), in which I basically said that central banks were making huge donations to investors, because gold would operate as depressurization valve of financial markets in subsequent years.
Gold rose to $ 1900 an ounce in 2011 but people only caught it when it exceeded a thousand. Then, like all the bubbles, it deflated and now it is around $ 1,300.

But the decisive factor, the Sign Of The Fate of the bubble, comes when the aversion in the initial and median phase of a trend then becomes a global and collective complacency in the final stage, when those I call the latecomers, the latest ones, which have often been the most arduous enemies of the trend itself, become, as they almost converted with an act of psychological self-relieving, the brightest supporters of the trend even when they are clearly in the bubble or already in deflation phase. When they understand that they have been entangled in the final part of a bubble, they do not come out because they do not want to admit to themselves that they heve been wrong so deeply.

It is a psychological posture of self-justification, a classic bias of denial of reality: the whole path of a bubble is a long denial of the reality of a trend that is developing. And then, it is the denial of the reality of excesses that are clearly developing on the market.

Financial bubbles are a completely irrational and totally human phenomenon. Men are at the origin of the bubbles and are the bubbles a completely irrational phenomenon?

Absolutely yes. If, however, the back of this question is the doubt that central banks favor bubbles, it must be said that even if they do not favor them directly, they can, and in fact do so, with their actions. Actions certainly dictated by totally different reasons but that in fact creates bubbles on assets.
Example: a bubble we are still experiencing is the zero rate bubble, an incredible economic irrationality. Why do I have to invest in something that makes earn me less than the standing still? This bubble was clearly indirectly fired by the action of central banks, first the FED, then the BCE and Bank of Japan, to avoid an economic crisis that probably would have had much deeper effects than a mere recession.
Let us not forget that at the heart of all the great wars of recent centuries there have been economic crises; first an economic crisis, then a difficult transition and then the war. That is why Central Banks have decided to make a devastating move such as leaving the rates at zero or below, rather than letting the economies fall into an even deeper recession. To avoid the risk of subsequent steps. But everything has a price and these actions have distorted the market prices of many assets, first of all government bonds, which have reached absurd levels. If there was only a return to the mean, holders of many government bonds (and not only) in the coming years could not mathematically do anything other than losing money.

This bubble has already developed but continues to persist because no one deflates it.
It will be deflated as the economy resumes in a strong way and Central Banks will be forced to resume liquidity from the market; from quantitative easing to quantitative tightening. Clearly people will realize that bonds at this level are pure delusion and will begin to sell expecting higher rates in the future.

Other bubbles in preparation.

Many economic indicators are clear about the fact that the US stock market is now very expensive compared to historical parameters. The US financial leverage is at its highest, much higher than in the tops of 2000 and 2007 but it does not seem to be reversing the trend for now. Consumer confidence is at clear levels of euphoria. Schiller’s P / E has been higher than this only in the bubble of 2000. Now it is on 1929’s levels.

This chart, courtesy of, shows how apart from the decile of US securities with the highest PRR (!), all the other deciles have a PRR significantly higher than in 2000 and 2007.
This chart, courtesy of, shows how apart from the decile of US securities with the highest PRR (!), all the other deciles have a PRR significantly higher than in 2000 and 2007.

Warning: this does not mean that tomorrow the market should drop but it means that right now the US stock market is expensive; the ratio between the US stock market capitalization and the US GDP is also high and this is Warren Buffet’s favorite indicator. But at this time, the factor of lack of credible alternatives plays a great role. The money goes there and stays there because it can not go anywhere else. Think of a big insurance or a large pension fund that has to guarantee certain returns to its subscribers and it must also guarantee the cost of a business, staff and structure, if you have the performance of ten-year German bonds, which is the safest thing in the world, at 0.50 you can not do anything and you’re definitely in loss. So they too are forced to risk.
There are many strategies, such as Risk Parity, which is very fashionable and very extensive, based on passive instruments such as ETFs entering the market without regard to the value of this market. Within a few years the ETFs could account for almost 50% of the market and this is clearly a potential danger. When you go to a large bank to invest your money, you think that they follow a strategy and do all they need to do, but they often simply divide your money into bundles and buy funds or ETFs. By doing so they are not looking exactly at whether or not there is value on that market, the diversification theory on which their investment models are based simply states that.
This is because there are no alternatives.
The Italian investor has been used for decades to buy BOT and CCT or CTZ with yields of 10-15%, then 7-8%, then 6%, 4%, 2%. Now the investor goes to the bank and asks to buy an Italian government bond and finds that up to 5 years of expiration he has to pay the state and not the other way around. From then on he earns 0,… or 1,… etc. With his legacy of BOT and CCT, he asks himself whether there is anything where he can earn more. In the bank drawer, their fund which follows their strategies is ready to be bought. He is so desperate because he no longer has the yield he was accustomed to, and, often without knowing it and without understanding it, he goes from a very low risk investor to an aggressive investor. Behind the names flexible strategy, balanced strategy, etc. there are parts in instruments that the average prudent investor had never before touched.
Long story short, investors must become accustomed to risk and on the other hand they must understand it. The danger is otherwise to run into the boiled frog syndrome. Cold water warmed in slow fire, the frog bakes without realizing it. So the risk of your portfolio increases gradually because you have no alternative, until you realize too late that it is too high for you and you want to be a prudent or conservative investor. “Truth always comes in a precipice and without blows, as the long-feared misfortune suddenly comes to the man in a scarred form, with trivial formalities and man stumbles to conceive it.” (Buzzati, “A love affair”)

We will return to the topic in the next post. If you have found this post interesting, share it with socials. Understanding market mechanisms is beneficial to everyone.