In almost every bubble there are people who see it clearly and say so. Economists publish warnings, central bankers express concern, journalists question valuations and experienced investors explain why prices cannot be sustained. And in almost every bubble, their first warnings are too early. Prices keep rising, sometimes for years, and the people who sounded the alarm are dismissed, ridiculed or simply forgotten.
When the bubble finally bursts, the warnings are remembered. But by then many of those who issued them have lost credibility, clients or money by acting too soon, and many of those who ignored them have made large profits along the way, at least until the end.
This article explores why bubble warnings tend to come early, why overvalued markets can stay overvalued for so long, why even correct analysis is hard to act on, and how investors and business owners can respond sensibly to bubble risk without needing to predict the exact top. It is part of GoCore’s series on bubbles.
Early warnings are the norm
The pattern repeats across history.
During the late-1990s technology boom, the chair of the US Federal Reserve, Alan Greenspan, asked in a speech in December 1996 how anyone would know when “irrational exuberance” had unduly escalated asset values. Markets fell briefly, then rose strongly for more than three years. The technology-heavy NASDAQ index rose roughly fourfold after that speech before it peaked in March 2000.
Many analysts warned about high US house prices well before the peak of the housing boom in the mid-2000s. Prices continued rising for some time after the warnings became common.
Japanese share and property prices rose for years in the late 1980s while some observers questioned how they could be sustained. The peak came at the end of 1989.
In each case, the warnings were correct about the risk and wrong, sometimes badly wrong, about the timing.
Why being early feels like being wrong
In most areas of life, being early is an advantage. In markets, being early can be indistinguishable from being wrong. An investor who sells a booming asset two years before the peak may watch it double. A fund manager who avoids a booming sector may underperform competitors for so long that clients leave. A commentator who warns of a bubble may see prices rise so much further that even after the eventual fall, prices remain above where they were when the warning was given.
Why bubbles last longer than seems possible
Several forces allow overvalued markets to keep rising long after the warning signs are clear.
Momentum and feedback
Rising prices attract buyers, and buyers push prices higher. As long as more people want to buy than sell, prices rise regardless of valuation. Investors who follow trends, and investment strategies that buy what has been rising, reinforce the momentum.
Credit keeps flowing
As long as lenders continue lending against rising asset values, buyers can keep paying higher prices. The article Credit: the fuel behind every bubble explains how this feedback loop sustains a boom.
The pool of new buyers
Bubbles keep inflating while new participants continue to arrive. The peak often comes when the supply of new buyers is exhausted, which is hard to observe in advance.
Normalisation
The longer prices stay high, the more people come to see them as normal. The judgement that higher prices are permanent tends to be based on how long they have lasted, not on whether valuations make sense. Each month that prices hold makes the next month’s high price seem more reasonable.
Reasonable stories
A genuine new element, such as a new technology or a fall in interest rates, provides a plausible explanation for higher prices. As described in “This time is different”, this makes it hard to argue that prices have gone too far.
Why even correct analysis is hard to act on
Suppose you are confident that a market is in a bubble. Why not simply sell, or bet against it, and wait?
Limits to betting against a bubble
Betting against an overvalued market, for example by short-selling, is risky and expensive. Losses can be large if prices keep rising, borrowing costs accumulate while waiting, and positions may have to be closed at a loss if prices move the wrong way for too long. Economists sometimes describe these constraints as limits to arbitrage: even when prices are clearly wrong, the risks of trying to profit from the error can deter the investors who might otherwise correct it.
Career and business risk
Professional investors are judged against peers and benchmarks over relatively short periods. A fund manager who avoids a booming sector may lose clients long before being proved right. One widely quoted remark captures the dilemma. In July 2007, shortly before the financial crisis, the then chief executive of Citigroup, Charles Prince, said: “As long as the music is playing, you’ve got to get up and dance.”
The same pressure affects businesses. A lender that refuses to join a lending boom loses market share. A developer that refuses to buy land at boom prices may have nothing to build. A business that declines boom-time growth may look timid to staff and investors.
Riding the bubble
Some participants knowingly buy into a bubble, intending to sell before it bursts. This can be rational for an individual who believes they can exit in time, but it adds to the bubble’s momentum. And because everyone hoping to exit early is trying to do the same thing, many will be too late.
The economist John Maynard Keynes described investing as being like a newspaper beauty contest in which competitors must pick not the faces they find prettiest, but the faces they think others will pick. In a bubble, the question becomes less “what is this worth?” and more “what will others pay for it next month?”
Warnings that discredit themselves
Repeated early warnings can also weaken their own force. Each time a warning is followed by further rises, the public becomes more confident that warnings can be ignored. Commentators who have been “wrong” for several years lose their audience, and those who remain optimistic gain credibility. By the time conditions are most dangerous, the most cautious voices may have the least influence.
This is not a reason to stop warning, but it is a reason to frame warnings carefully. Warnings expressed as probabilities and risks (“the chance of a large fall over the next few years is high”) are more honest and more durable than predictions with dates (“prices will crash next year”). The first kind remains true even if prices rise for a while; the second is easily discredited.
The trigger is unpredictable
Bubbles end when a trigger causes enough participants to doubt that prices will keep rising. Triggers include rising interest rates, economic slowdowns, external shocks, corporate failures and the arrival of excess capacity. Sometimes the trigger is so minor that it is hard to identify even afterwards: the straw that breaks the camel’s back.
Because the trigger can be almost anything, and because the market’s vulnerability builds gradually, predicting the exact moment of the turn is close to impossible. Analysts who try to time the peak are usually wrong, and those who are right once may simply have been lucky.
Forecasters and their track records
It is worth remembering that some of the people celebrated for predicting a bust had been predicting one for many years, and some went on to predict busts that never came. A correct call after years of incorrect ones may be insight, or it may be the eventual result of always saying the same thing. Judging forecasters by their whole record, rather than by their most famous call, gives a more realistic view of how predictable bubbles really are.
How to act without predicting the top
If timing is so hard, what can investors and business owners do with bubble analysis? The answer is to use it to manage risk rather than to predict dates.
Think in probabilities and ranges
Rather than asking “when will it burst?”, ask “how much risk is there, and how would I fare if it burst at any point in the next few years?” A market showing many warning signs, as described in Warning signs of a bubble, carries a high probability of a significant fall at some point, even if the timing is unknown.
Adjust gradually
Rather than making a single all-or-nothing decision, reduce exposure gradually as risk rises. An investor might trim holdings as valuations move further above average. A business might shift towards flexible capacity and build reserves as boom signs accumulate. Gradual adjustment reduces the cost of being early while still providing protection.
Avoid the most dangerous exposures
Some exposures are far riskier than others in a bubble: heavy borrowing against inflated assets, buying assets at peak prices with no margin of safety, depending on a single booming customer or industry, and committing to large fixed costs on the assumption of continued growth. Avoiding these is often more important than getting the timing right.
Keep resources for the bust
Those who stay disciplined during a bubble may miss some gains. Their reward comes later: cash and borrowing capacity when assets are cheap, competitors are weakened and opportunities are plentiful. The article Price and patience describes this approach.
Accept the cost of caution
Caution during a bubble has a real cost: forgone profits, uncomfortable conversations and the risk of looking foolish for a while. Accepting that cost in advance makes it easier to bear when it arrives.
A worked illustration
This is an illustration with round numbers.
An investor holds $500,000 in a share market that, by several measures, is well above its historical valuation. Two strategies are considered.
Strategy A: wait for the top. The investor stays fully invested, planning to sell when signs of a peak appear. Prices rise another 30% over two years. The investor waits for confirmation of the turn, which comes only after prices have already fallen 25% from their peak. Selling then leaves the investor slightly below where they started.
Strategy B: adjust gradually. The investor reduces holdings by a tenth each time valuations move further above average, moving the proceeds into lower-risk assets. They miss part of the final rise, but when the fall comes, a smaller share of their portfolio is exposed, and they hold cash to buy when valuations return to normal.
Neither strategy requires predicting the top. Strategy B accepts some cost of being early in exchange for much better protection, and positions the investor for the opportunities the bust creates.
What this means for business owners
Business owners rarely need to decide whether to sell shares at the top. But they make similar decisions constantly:
- whether to expand capacity in a booming market
- whether to buy premises or equipment at current prices
- whether to take on debt while credit is easy
- whether to depend on customers in a booming industry
In each case, the same principles apply. Treat warnings as information about risk, not about timing. Adjust gradually rather than all at once. Avoid the commitments that would be most damaging if the boom ended suddenly. And keep enough in reserve to act when conditions change.
Common mistakes
Dismissing warnings because they have been wrong so far. Early warnings are often correct about risk.
Waiting for certainty before acting. By the time the turn is certain, much of the damage is done.
Trying to pick the exact top. It is close to impossible to do consistently.
Making all-or-nothing decisions. Gradual adjustment reduces the cost of being early.
Underestimating how long bubbles can last. Plan for the possibility that prices rise further before they fall.
Questions to ask
- How many warning signs are present, and are they intensifying?
- How would I fare if prices fell sharply at any point in the next few years?
- Which of my exposures would be most damaging in a bust?
- Can I reduce risk gradually rather than all at once?
- For your own business: what commitments are you making on the assumption that the boom will continue?
Bringing it together
Bubble warnings usually come too early because bubbles last longer than seems possible. Momentum, continued credit, a steady supply of new buyers, normalisation of high prices and persuasive stories keep prices rising long after the warning signs are clear. Even correct analysis is hard to act on, because betting against a bubble is risky and because professional and business pressures reward participation.
The sensible response is not to predict the top but to manage risk: think in probabilities, adjust gradually, avoid the most dangerous exposures and keep resources for the bust. That approach accepts the cost of being early in exchange for protection when the warnings finally prove right.
Sources: an introductory chapter on asset bubbles written in the mid-2000s and widely documented market history. The worked illustration is hypothetical. This article is general information, not financial or investment advice.
