Bubbles and stock market crashes
August 9, 2018 4:28 AM   Subscribe

Looking for theories on how to identify bubbles and imminent stock market crashes

So I want to be able to have a better idea of how to take temperature of how overheated a market is. There is so much information and opinion out there that I'm at a loss for where to start.

Looking for reputable books, articles, and personal insights that are intermediate-advanced with theories on this! Thank you! :)
posted by Crookshanks_Meow to Work & Money (17 answers total) 7 users marked this as a favorite
Ideally I would like case studies of previous market crashes. Thanks again!! :)
posted by Crookshanks_Meow at 5:36 AM on August 9, 2018

The big short is a great book on the subprime bubble and crash.
I also read a good book on the tulip bulb bubble, think it was called tulip mania.

Finally, the skyscraper index is a fun signifier of irrational exuberance!
posted by JonB at 5:54 AM on August 9, 2018 [2 favorites]

The big short is definitely a good read / movie. I particularly liked the movie. I think it would be a great starting point.

But, some of the best financial advice I've gotten is that you shouldn't try to time markets. If you consistently put money in, like $500 every month, it will give you better results on average than if you hold on to your market and only put money in once or twice a year.

On top of that, if you are like me, you don't have several million dollars to shift around in fancy same-day transactions. Typically, with small investments, there's a large time delay to getting invested/getting out of a market. And that ruins any chance of timing it in a meaningful way.

A lot of people make their living trying to time markets with other people's money. And, they don't usually beat the market average. And, you have to pay their salaries.


this is a great article about timing the market!
posted by bbqturtle at 6:09 AM on August 9, 2018 [2 favorites]

If back in 2001 when I started my Real Job I had ignored my workplace financial advisor who said that real estate is always safe and had instead invested everything I invested in real estate in social justice crap, I'd probably be about where I am today without having aided and abetted that particular vampire industry. Or I'd have a few more or a few fewer dollars; whatever; it's all a mystifying and intolerable mandated gamble that I hate.

What about Extraordinary Popular Delusions and the Madness of Crowds? I bought it because the title is so incredible and always meant to read it. I think it deals with tulips, etc.
posted by Don Pepino at 7:00 AM on August 9, 2018 [2 favorites]

Some believe the inversion of the yield curve can predict a recession. Others believe that it's not applicable anymore.

And everyone knows that you can't time the market.
posted by JoeZydeco at 7:19 AM on August 9, 2018

Anybody who actually knows how to "take the temperature of how overheated a market is" or who can actually "identify bubbles and imminent stock market crashes" is not going to share that information, but use it to get rich.

So, seconding the advice that looking for theories on how to time the market is the wrong approach. The right approach is to look for the best allocation of investments among various asset classes, stick with it and re-allocate rarely (and not based on theories about coming crashes).

To that end, Jeremy Grantham and his outfit (GMO: Grantham, Mayo, Van Otterloo) have done some interesting work on dissecting market cycles. Earlier this year he proposed that the market was going to do a "melt-up" followed by a "melt-down" and made suggestions for coping with that. For some time, GMO has been suggesting (PDF) taking a large position in "emerging value stocks", stating that "Emerging market value stocks are the best asset we can find, by a margin that is just off of the largest we have ever seen." Grantham himself has just published "The Race of our Lives Revisited" (PDF), in which he presents his market perspective on dealing with global climate change, with suggestions for what investors can do to move the needle back in the right direction while making some money as well. It's a "theory" well worth reading and considering in lieu of any market timing theory.
posted by beagle at 8:20 AM on August 9, 2018 [9 favorites]

Well I literally do for a living what GMO is telling people to do, they are mostly saying that's the least bad option. Regardless the rule of thumb is you can tell when a bubble exists or a market is out of whack, but you can't tell when it blows up, and on a long enough time line it actually doesn't matter much.

Regardless the classic text on this topic is "Extraordinary Popular Delusions and the Madness of Crowds"

Also probably more enjoyable is "Devil take the Hindmost - A history of Financial Speculation"
posted by JPD at 8:54 AM on August 9, 2018 [1 favorite]

This is the kind of question that, if you're asking it, means you shouldn't be investing any money on the basis of the answers (at least the ones that purport to answer the question directly rather than challenging the premise). You are deep in the land of not knowing what you don't know. I don't say that to be offensive--it's the natural starting point for us all in new fields, after all--but to vigorously dissuade you from investing money on that basis, because I don't want to see you fleeced the way so many are. If you want to start investing immediately, put your money in some very-low-fee index funds, perhaps a Vanguard target-date retirement fund that will handle allocation for you, while you do some reading and reach the conclusion that...you should be in very-low-fee index funds, only adjusted a bit for your particular risk tolerance and investment horizons.

Reading about crashes and market catastrophes is fun, though. In addition to The Big Short, there's When Genius Failed (about a hedge-fund blow-up that almost took the market with it) and The End of Wall Street. A Demon of Our Own Design and Fools' Gold are a bit more technical.
posted by praemunire at 8:58 AM on August 9, 2018 [7 favorites]

I like Mr. Money Mustache, though he's an acquired taste for some. He's written on the topic once or twice.

Next Recession

Scary Markets
posted by craven_morhead at 9:30 AM on August 9, 2018 [1 favorite]

Hi guys! Thank you for your responses, and yes, I definitely could have asked with more precision. But with respect, some of these responses are a bit patronizing. I have heard about the dangers of speculative investment, and it's not one of my interests. That also was not part of the question, if you read the actual wording, it does not mention wanting to use this information to inform my investment decisions or 'timing the market'. Not that it's even relevant, but I don't like speculative investing or trading. Advice about looking at the intrinsic value of assets through financial analysis is also very kindly intentioned but not relevant to the question.

Just to reiterate, I am hoping for more books / articles / insights on where to investigate first, based on precedents, when the market feels imbalanced so that I can either confirm or disprove these hunches. A lot of the previous stock crashes seemed to have been caused by (i) market overreactions for demand for products with low intrisinc utility (e.g. bitcoin, tulips) or (ii) market failures in the credit market (e.g. 2007-9). Looking back, what are some other causes of crashes, and what were the warning signs for each particulate case? What are the simliarities and differences between each crash?

Which metrics are most relevant to assessing whether a certain asset / market is growing an unsustainable level?

Of course I'm not expecting easy answers, but more case studies to chew on would be really great. Thought Big Short was excellent in its coverage of subprime mortgages in the US, although books and articles about what was going on in other markets e.g. Greece, Italy, BRIC countries would also be well appreciated.

In conclusion, sorry for the confusion, I think what I want is to have a better understanding and awareness of international stock market history. Please share your insights on that if you have any.
posted by Crookshanks_Meow at 10:16 AM on August 9, 2018

The book closest to what you want that I know of in English is Reinhart and Rogoff's This Time Is Different, but it won't fit your belief that bubbles are primarily a phenomenon of stock markets.
posted by praemunire at 10:31 AM on August 9, 2018 [1 favorite]

I didn't study all the links included, but the financial crisis observatory has been releasing monthly reports on bubbles.
posted by Dmenet at 11:59 AM on August 9, 2018 [2 favorites]

Honestly, people might seem patronizing because the question you're asking -- "How can I find more info about predicting market peaks?" -- is considered by many to be a beginner's question, one that reveals fundamental misunderstandings about the market (and markets, in general). I almost replied to your question this morning (when it had zero answers), but I moved on because I didn't want to get into it. I'll get into it now.

The short answer, and the answer you don't want to hear, is nobody can predict peaks. You're not going to find the info you want because it doesn't exist. Yes, there are lots of folks who purport to have answers. They don't. If they did, they'd get rich from the answers. They never get rich. Why? Because they don't have the answers.

It doesn't matter if you're not wanting this info to make some sort of investing decision, what you're talking about is still market timing.

Here's the thing: No two crashes are the same. Each is different. (Here's a recent article from Vanguard on this subject: Why it's so hard to predict the next bear market.)

The best that anyone can do is to make general subjective statements about the current market state, just as they might about the weather before the age of meteorology. "It's sunny today, but something about the wind and the clouds makes me think we could have rain tomorrow." --> But the rain doesn't set in for three more days.

The same is true with the stock market.

I've been reading and writing about money full-time for the past twelve years. I can tell you that not a single week has gone by in that past twelve years during which I haven't read an online article about how the market is due to drop. This happened during boom times in 2006, it happened during the Great Recession, it happened after the recovery started, and it's happening now. Like a broken clock, these writers are correct now and then.

It's precisely because there's no way to identify imminent stock market crashes that "passive investing" has come to prominence over the past forty years. The math -- and history -- make it clear that you're better off not trying to guess when crashes will occur.

Now, if you remove your request for "reputable" sources, there are tons and tons out there. And, obviously, there's no end to books about past crashes. But past crashes do not teach you how to predict future crashes.
posted by jdroth at 3:47 PM on August 9, 2018 [7 favorites]

The short answer, and the answer you don't want to hear, is nobody can predict peaks.

He is asking two separate questions. Can you recognize bubbles and can you recognize a crash? While it can be difficult to know exactly when a bubble will burst, you can certainly recognize the bubble and position yourself to avoid the worst of it.

Bubbles are caused by irrational behavior. You can recognize irrational behavior. People do it every day in their personal interactions when you run into irrational people and you can do it with financial bubbles as well. In financial bubbles people behave very irrationally, and to deny that fact is to just throw up you hands and run off the cliff with the other lemmings.

Before the 1929 crash an obvious sign was the apocryphal elevator operator giving stock tips. You could see large numbers of uneducated people piling into a market they didn't understand. That should have been a clue to an irrational bubble.

In 2000, there were billion-dollar IPOs for dot-com companies that not only didn't have any profits, they had never collected a dime of revenue. That should have been a clue to irrational behavior.

In the mid-2000s, the housing bubble was easy to recognize because there were no fundamentals supporting it. Prices for houses were doubling and tripling even as equivalent rents were flat and rental vacancies were at all time highs. That's obvious irrational behavior.

Now, it isn't easy to say exactly when a bubble will burst, but to say it is impossible to recognize obviously irrational behavior is nonsense. And to protect yourself from the irrational bubble, just keep yourself from following the crowd that is behaving irrationally. You don't have to time the crash perfectly. Just avoid the crazy behavior.

As others have mentioned, the two best books that might give you an idea of how to recognize irrational bubbles are Extraordinary Popular Delusions and the Madness of Crowds and Devil Take the Hindmost.
posted by JackFlash at 5:10 PM on August 9, 2018 [3 favorites]

And to protect yourself from the irrational bubble, just keep yourself from following the crowd that is behaving irrationally. You don't have to time the crash perfectly. Just avoid the crazy behavior.

"The market can stay irrational longer than you can stay solvent."

Now that applies primarily to people who choose to try to speculate, but are you genuinely under the impression that a person could have protected themselves from the housing bubble of the mid-aughts by simply not buying real estate? Because I would say that there is very little evidence for that theory.
posted by praemunire at 6:54 PM on August 9, 2018

are you genuinely under the impression that a person could have protected themselves from the housing bubble of the mid-aughts by simply not buying real estate?

You could certainly have protected yourself from being foreclosed on an underwater house and going bankrupt.
posted by JackFlash at 7:57 PM on August 9, 2018

nthing Extraordinary Popular Delusions and the Madness of Crowds, it's a great read
posted by 5_13_23_42_69_666 at 9:42 PM on August 9, 2018 [1 favorite]

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