Bubbles & How to Survive Them

A series of bubbles and busts in stock markets and home prices have played a central role in the world economy over the last 20 years. The volatile ups and downs of such asset prices may now be a greater threat not only to economic stability but also to the financial wellbeing of investors, home owners and pension holders. When Japan's stock and property bubbles burst in 1990, land prices declined 90% and the Japanese economy was shattered, leading to a lost decade of slow growth. Then in the late 1990s Fed Chairman Alan Greenspan stood back and watched as US and then European investors abandoned normal valuation criteria and created the biggest stock market bubble since the 1920s. Economies boomed and money flooded into the markets with the conviction that stocks always outperform in the long run. After the inevitable collapse in 2001-2 a new recession followed in the US and much of Europe. But the authorities had learnt the lessons from Japan and the 1930s and avoided a major downturn with rapid cuts in interest rates and the largest fiscal stimulus in US history. But there was a price. Low interest rates have inflated housing bubbles, at first mainly in the UK and Australia but now in the US too. Many investors have abandoned stocks and pensions and turned to housing to secure their retirement. The new mantra is safe as houses - prices always rise in the long run. Yet, if the new housing bubbles burst, past evidence suggests that falling house prices will impact consumer spending far more than stock busts. Calverley investigates why bubbles occur, focusing on the interaction between interest rate policy and the psychology of investor behaviour. Central banks are still targeted to control consumer prices but, like old generals, they may be fighting the last war. The theories of behavioural finance and critical states shed new light on why investors lose track of reality and how just a small event can trigger a market crash. Controversially, the book argues that we can identify bubbles as they emerge, based on market valuations and a checklist of other factors. Armed with this knowledge there are ways to prevent bubbles inflating too far by designing speed limits'' on bank lending. Meanwhile investors need to find ways to protect themselves. Some may try to ride bubbles, exiting at the top, but market timing is always difficult and risky. A more balanced approach is to focus on avoiding their worst effects by holding a diverse portfolio and adjusting away from bubbling assets, such as housing.

About the Author :
John P. Calverley is Chief Economist and Strategist at American Express Bank. Based in London he is responsible for the Global Economics Unit's economic and investment research capability, advising management and clients. He edits the Bank's suite of publications on economic and market trends, Economics for Investment. He is the author of numerous articles on international economic issues and several books.