Common patterns of bubbles: leverage, narratives and crowds

What you will learn

• A working definition of a bubble and the five classic stages of a mania
• Three recurring ingredients: leverage, narratives and crowds
• A checklist of warning signs you can use on any market
• How a loan-to-value limit forces leveraged investors to sell into a falling market

Explanation

Herd behaviour as a personal bias is covered in the psychology course; here we look at it as a market-wide pattern.

What is a bubble?

A bubble is a period when prices rise far above what reasonable assumptions about future cash flows (profits, rents, interest) can justify, and the main reason to buy is the expectation that someone else will pay more later. A bubble can only be confirmed afterwards. Prices can also be high for good reasons.

The five stages

The economist Hyman Minsky argued that long stable periods encourage more and more borrowing. The historian Charles Kindleberger used his ideas to describe five stages in his book Manias, Panics, and Crashes:

1. Displacement: a real change, such as a new technology (railways, the internet) or a policy change.
2. Boom: prices rise, credit expands, early buyers earn real profits.
3. Euphoria: caution disappears; new buyers enter because prices have risen; "this time is different".
4. Distress: insiders sell, price rises stall, the first borrowers struggle.
5. Revulsion: prices fall fast, lenders cut credit, people refuse to touch the asset at all.

Minsky also described three kinds of borrowers: hedge borrowers can pay interest and principal from income; speculative borrowers can pay only interest and must refinance; Ponzi borrowers can pay neither and depend on rising prices. The share of the last two grows during a boom.

Three ingredients across this course

The third ingredient is the crowd: rising prices attract attention, media coverage and new buyers, which push prices higher. This feedback loop is sometimes called reflexivity.

A warning-sign checklist

• Valuation far above the asset's own long-term history, for example a high cyclically adjusted price-to-earnings ratio (CAPE: price divided by average inflation-adjusted earnings of the last ten years).
• Fast growth in borrowing to buy the asset.
• A wave of new supply: new listings, new tokens, new funds.
• Many first-time buyers, and friends asking how to get in.
• Arguments that old valuation rules no longer apply.

A checklist describes risk; it does not time the top. US central bank chair Alan Greenspan warned of "irrational exuberance" in December 1996, more than three years before the dot-com peak. Use the checklist to limit leverage and position size, not to bet on a crash date.

Worked example

Hypothetical example: an investor has €10,000 and borrows €30,000 to buy €40,000 of an asset. The lender allows a maximum loan-to-value (LTV) ratio of 75% (loan ÷ asset value). Interest, fees and taxes are excluded.

1. Start: LTV = €30,000 ÷ €40,000 = 75%. Equity €10,000.
2. The asset falls 20%: value €32,000. Equity €32,000 − €30,000 = €2,000, a loss of 80% on own money.
3. New LTV: €30,000 ÷ €32,000 = 93.75%, above the 75% limit.
4. Required sale x, using the proceeds to repay the loan: (€30,000 − x) ÷ (€32,000 − x) = 0.75, so €30,000 − x = €24,000 − 0.75x, so x = €24,000.
5. After the sale: asset €8,000, loan €6,000, LTV 75%.

A 20% price fall forced the investor to sell 75% of the holding. When many investors do this at once, their selling causes the next price fall. This is how leverage turns a decline into a crash.

Second example, valuation: a share costs €100 and earns €2 per share (price-to-earnings ratio 50). Even if earnings grow 10% a year for ten years, they reach €2 × 1.1¹⁰ ≈ €5.19. At a more normal ratio of 20, the share would be worth about €104, barely above today's price after ten years of strong growth.

Common mistake

Practice activity

On paper: a hypothetical investor buys €10,000 of an asset with €5,000 own money and a €5,000 loan. The maximum LTV is 50%. The price falls 30%. (1) Calculate the asset value, equity and LTV. (2) How much must be sold to restore 50% LTV? (3) Name two items from the checklist you would check before such a purchase.

Key takeaways

• Bubbles follow recognisable stages from displacement to revulsion, but they can only be confirmed afterwards.
• Leverage, a convincing narrative and crowd feedback appear in almost every episode in this course.
• Loan-to-value limits force sales into falling markets, which deepens the crash.
• Use warning signs to reduce leverage and size, not to predict the exact top.

Next step

In the final lesson you will apply these historical patterns to your own finances by stress-testing your plan.