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How Market Bubbles And Manias Can Turn Ugly And Extreme

Throughout the history of trade, there have been bubbles and manias. Perhaps the most famous was the tulip mania that gripped Europe in 1637, when a single tulip bulb sold for around ten times the annual salary of a skilled craftsman. Of course, this level of insanity couldn’t continue and the price of tulip bulbs duly crashed, leaving those investors who failed to get out in time in a very unfortunate position.

Dotty prices

In fact, experiencing losses at the hands of a bubble or mania is a lot more common than many investors realise. Even in the last fifteen years there have been a handful of major bubbles. Some of them have burst, but others are yet to do so.

For example, the dot.com bubble of the late 1990s and early 2000s was perhaps less crazy than tulip mania, but left equally dire consequences for holders of tech stocks. On the one hand, the internet has had a major impact on the way business is done, how consumers consume, and the nature of people’s interaction with each other.

However, on the other hand, the idea that companies that had minimal assets, no revenue and little more than an bright idea (and not always that) could be worth millions was obviously quite ridiculous. Inevitably, the bubble burst and the prices of such companies collapsed — to zero in many cases — leaving their investors (perhaps better called speculators) with little or nothing.

Fuelling the fire

Of course, it could be argued that getting out of such bubbles before they burst is a sound way to make money. George Soros — the hedge fund investor famous for making £1bn by betting against the Bank of England — apparently subscribes to this view, saying that when he sees a bubble forming he “rushes to buy, adding fuel to the fire”. Clearly, such a move is risky, but can yield spectacular returns, so long as the position is sold before the bubble bursts.

The challenge, though, is identifying the right moment to sell. Realistically, this is impossible to do accurately and consistently.  For example, long before the dot.com bubble burst there were signs that the valuations of tech stocks had gone above and beyond any reasonable level. However, they kept going up, and so investors were faced with the choice of either not taking part in the huge price rises that were making so many people paper millionaires, or else risking being caught swimming naked when the tide turned.

Never ending story?

Perhaps the most talked about bubble at the moment is the UK property sector. As a multiple of average earnings, it is now at its highest level since April 2008, with average house prices at 5.35 times the average salary in the UK. The only time it has been higher since records begin in 1983 was between April 2006 and March 2008, after which time house prices fell by 19% within a year. That’s not to say house prices will fall over the next year, but it does provide an indication that the seemingly never-ending price rises of recent years may be coming to an end.

Perhaps this, then, is the obvious conclusion to draw from bubbles. In the short run, they can be an investor’s best friend, and lead to vast gains in a relatively short space of time. However, once valuations are either historically high or are seen built on smoke and mirrors, rather than profitability or some tangible value of an asset, it’s time to sell up and walk away. The discipline to do this, though, is incredibly difficult to summon, but one thing is for sure — selling into a bubble means that you will have sufficient cash to sit back, relax and wait for the next one to appear.

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Peter Stephens has no position in any companies mentioned. The Motley Fool UK has no position in any of the companies mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.