Financial bubbles are inevitable. Unfortunately, this is not a controversial statement. The undoubted benefits of capitalism seem only available with the unavoidable trauma of periodic boom and bust.

At least since the advent of the modern market economy in the early 18th century, the pattern of vaulting boom followed by depressing bust has been a constant. While the details differ, there is little fundamental difference, for example, between the South Sea bubble which so entranced the London of Isaac Newton, and the property bubble which so gripped the Ireland of Bertie Ahern.

Famously, Isaac Newton lost a substantial fortune when the South Sea bubble burst in 1720. Despite his early success, one of the greatest minds ever was undone by a dramatic financial collapse. His rueful admission over 300 years ago remains a timeless insight for investors today:

 ‘I can predict the movement of heavenly bodies, but not the madness of crowds.’

Shortly after the collapse of Lehman Brothers in September 2008, Queen Elizabeth opened a new building at the London School of Economics. Amid the gathered dignitaries, including some world-renowned economists, she famously asked the question about the dramatic crisis dominating headlines around the world: ‘This is awful. Why did nobody see it coming?’

In response, the British Academy convened a forum the following June of experts from ‘business, the City, its regulators, academia and government’, and summarised their answer in a letter to Buckingham Palace a month later. Tellingly, the letter is more a summary of the confusion that stunned conventional thinking than a satisfactory answer to the question. In truth, when the most serious financial and economic crisis since the great depression erupted, the response of conventional economic thinking can best be described as shock.

For many reasons, the bursting of financial bubbles is impossible to predict. Contrary to the confident pronouncements of many, the bewilderingly complex and jaggedly dynamic interactions of financial markets are beyond forecast. Inescapably, the sudden and wrenching lurches in expectations make occasional financial collapse as inevitable as it is unpredictable.

Until his retirement in 2010, Paul McCulley was the Chief Economist of Investment Management firm PIMCO. Today, McCulley is probably best known for coining the term ‘Shadow Banking’ in 2007. On what proved to be the eve of the global financial crisis, his insightful definition of ‘the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures’ proved both prescient and lasting. Less well known but arguably as importantly, he had also coined the phrase ‘the Minsky Moment’ to capture the Asian Financial Crisis ten years earlier.

Hyman Minsky was a US economist best known for his provocative 1975 paper ‘The Financial Instability Hypothesis’. In contrast to the mainstream consensus, Minsky theorised the possibility of financial and economic collapse:

‘The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.’

More specifically, Minsky outlined the three financing regimes – Hedge, Speculative and Ponzi – and how the dynamic from stability to instability is driven by changes between them:

‘Hedge financing units are those which can fulfil all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to “roll over” their liabilities: (e.g., issue new debt to meet commitments on maturing debt). For Ponzi units, the cash flows from operations are not sufficient to fulfil either the repayment of principle or the interest due on outstanding debts. It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system.’

Stock investors have enjoyed remarkable returns in recent times. From a low of 666 in March 2009, the widely followed S&P 500 Index of US stocks recently broke 4,300. Arguably more remarkably, the index is now up over 80% from the pandemic panic low on the 23rd of March last year, and the gain in global stocks in the first six months of this year was the best since 1982 and the 7th best in the past 100 years. According to Bank of America, the recent surge in stock prices has been driven by the largest annualised inflow to stocks ever recorded.

This recent quote from the Financial Times on the striking success of the financial trading platform Robinhood – one among many such services – captures the mood well:

‘Customers are flocking to the platform – Robinhood has become synonymous with the boom in retail investing that has drawn millions of people to the markets – many for the first time – to join the roaring rally that began in March (2020) and this week pushed the S&P 500 to an all-time high.

Significantly, the record high in stock prices has been accompanied by a surge in margin debt as many investors, and anecdotally many first-time investors, buy stocks with borrowed money.

Also, significantly, the stock-market value of firms with earnings before interest and tax (EBIT) less than their interest expense has also surged. While many of these firms will benefit from the reopening recovery, there is a strong likelihood that in Minsky terms many are speculative or Ponzi units – surviving for now by borrowing to service their debt.

In grappling with fragility and uncertainty, the John Kay parable of driving in France is one of my favourites. To shave journey time on the motorway, many drivers employ a ‘tailgating’ strategy of driving very close to the car in front. Consequently, on almost all trips they succeed in arriving at their destination sooner, while very occasionally they crash and cause a tragic pile-up. In the aftermath of such a pile-up, there is always a proximate cause offered as an explanation – mechanical failure, driver error, tyre issues or whatever – while the real cause is the ‘tailgating’ strategy which inevitably results in a pattern of many small gains (time saved) followed by a dramatic loss (crash and pile up).

As Newton discovered to his cost, the future is necessarily unknowable, but stock investors today should ponder whether they are speeding dangerously close to the vehicle in front. The gains have been spectacular, the flows have been enormous, and the leverage of many investors and many firms is historically high. Although impossible to predict, it’s time to ponder the growing possibility of a Minsky Moment.