Over the past two decades we’ve seen two major bubbles develop: the internet bubble, which burst in March 2000, followed by the real estate and mortgage bubble, which burst in 2007.
Now, we’re entering a stock market bubble in a manner we haven’t seen before, said Jim Puplava, founder of Financial Sense, in a recent podcast, Anatomy of a Bubble.
Bubble Stage One
It all begins with an attention-grabbing idea, Puplava stated.
“For bubbles to take place, what you usually see throughout history is suddenly the whole community becomes fixated on one object and they go mad in pursuit,” he said. “Millions of people become simultaneously impressed with one illusion, which develops into a delusion.”
We’ve seen this play out throughout history, with the Tulip Mania in the 1600s or, more recently, with internet stocks and real estate.
As the bubble forms, what fuels it is the prospect of imaginary wealth. The public becomes infatuated with the idea that promises fast, easy money, Puplava stated.
Next, the idea becomes widely publicized, and this publicity reinforces the idea, which begins to transform into an illusion. Next, cheap money and credit fuel its rise.
“When the prospect of great riches and fast and very easy money is made, what are investors tempted to do?” Puplava asked. “They go out … and borrow money.”
Leverage comes in, and the banking system gets involved because there is a spread between low interest rates and the cost of borrowing money, which encourages banks to lend money, Puplava noted.
Bubble Stage Two
This is the euphoria phase, where an investment concept that likely had merit originally, shifts into the illusory phase of speculation.
“What was once rational becomes irrational, with everyone seeking to become rich,” Puplava said, “because there’s nothing more disturbing to one’s psyche, well-being, and judgement, as to see a friend get rich.”
When whole institutions begin to get rich, the exuberance catches a large swath of the population’s imagination. Then speculation moves away from what is normal and becomes irrational behavior, and that’s when the bubble begins to inflate with rapid speed.
There’s no fundamental analysis. People just buy the underlying asset without thinking. After the public swarms in, and everybody thinks nothing can go wrong, we turn to the final phase of the bubble.
Bubble Phase Three
In the final phase, as we watch the bubble’s speculative mania continue, we see a number of things.
First, interest rates begin to rise, which is what we’re seeing now, Puplava noted. Next, money velocity starts to increase, and prices continue to mount to the point where unease and financial duress begin to take hold.
At this point, the smart money — those closest to the exits — begin to gradually move out of the asset and into cash to get liquid. As this trend builds, it results in severe consequences for asset prices.
Eventually, there’s a realization that the bubble isn’t sustainable. From here, what was a gradual exit transforms into a selling stampede. There is usually an event — an overleveraged player that goes belly up — that takes place toward the end that precipitates a crisis.
“That’s the thing about the bear market,” Puplava said. “A bull market climbs a gradual step. … Bear markets happen rapidly, and the declines are swift. All of sudden, greed turns to panic, which turns to revulsion.”
Where Are We Now?
These are the conditions we’re seeing develop in the index funds and index ETFs right now, Puplava stated, and this is the epicenter of the current bubble. He thinks we’ll enter into the final stages at the end of this year or the beginning of next year.
This move toward passive investing in the form of an index ETF or an index mutual fund is generating the same behavior we’ve see in past bubbles.
“It’s being driven by computers,” Puplava said. “No thought is given to what is bought or sold. It’s the downfall of human psychology.”
Right now, it is estimated that $800 billion will flow into index ETFs this year, up 60 percent from the previous year, and next year it’s estimated we will top over $1 trillion.
As we’ve seen in every crisis, the implosion of margin debt eventually brings this to an end. As this happens, it accelerates the stampede out of the bubble asset. That’s how every cycle always ends.
Echoing Ray Dalio's recent comments, Puplava, who has been managing money for over 30 years, ended by saying, “Right now, we’re still dancing.” However, as we move into the final phase of the bubble, Puplava intends to take profits, raise cash, and take advantage of potentially cheaper prices once the tide turns.