Market bubbles have been with us as long as we have had markets.

Their causes and subsequent recovery paths vary but all share a common characteristic; they occur amidst a wave of enthusiasm as hope triumphs over common sense. In each case the market valuation of underlying assets inflates prices to unsustainable levels, triggering a massive rush for the exit when the truth becomes obvious.

While some are brief technical corrections, the bigger bursts are harbingers of bear markets during which time the market often over corrects and under prices equities.

A burst of emotion

The process is as much an emotional catharsis as it is an economic adjustment. In the Tulip Mania of the 17th century, the price of a tulip bulb rose from one gilder to sixty whereupon it peaked and precipitously dripped back to one, triggering a massive downturn in Holland’s economy and a distrust of speculative investments.

France endured the Mississippi bubble of 1718 when shares of the Compagnie des Indes rose to astronomical heights and then crashed when the public discovered the promise of riches in North America were pipe dreams.

Not to be outdone, Britain created the South Sea Company to exploit the riches of South America with similar results. The subsequent crash ruined many people and sent Britain’s economy into a severe downturn.

Whether it is tulips or stocks, the common thread among bubbles is the belief in belief itself. In a bubble, actual facts of earnings and real value disappear in the welter of optimism and expectation. The game seems as though it will go on forever, with each rise in value reflecting ever more optimistic assessments of future returns.

A unyielding faith meets its maker

The driving force behind bubbles does not erupt solely from the public’s unyielding faith in the market’s promise. It is also driven by the culpable participation of financial institutions. Prior to the mortgage meltdown of 2007 to 2009, banks routinely used VAR (variance at risk) as a measure of their exposure to risk.

The watered down version of the VAR statistic allowed banks to use past history as their guidepost of the mortgage market’s lurking dangers. Looking back, they saw low default rates for the immediate past and concluded the danger was negligible, allowing them to vastly over leverage their positions, sometimes reaching a hundred to one and more. Using VAR as a blinder, they over committed their capital, resulting in the need for a FED bailout when the crash hit.

Another impetus behind bubbles is the emergence of untested investment vehicles. In 1907 the untested Trusts, a new form of investment, failed when Knickerbocker Trust found itself caught up in scandal. In 1929 the largely unregulated Investment Trust companies helped push the market over the edge.

When the State of Massachusetts declared that Boston Edison was worth 215 a share instead of its market price of 375, it triggered a wave of selling culminating in the crash at the end of October as the over leveraged Investment Trusts were caught trying to sell into a market with few buyers.  In the more recent mortgage crisis, CDOs (collateralized debt obligations) were unknown to the public but were a driving force behind the market’s collapse.

The public only becomes aware of the size of these hidden instruments after the fact. The trigger for their collapse can come from anywhere, even natural disasters as in 1906 when the San Francisco earthquake led to the panic of 1907.

Are we in a bubble now?

Regardless of their causes, investors understand that a bubble can destroy their portfolios and therefore want to know when the next one is coming. More often this question takes the form of, ‘Are we in a bubble right now?’

A definitive answer to the question is elusive but perhaps it is the wrong question. The right question is, are equities overvalued and if so by how much. If you bought a stock at eleven times earnings and its price has doubled but its earnings multiple is still eleven, then it is probably not overvalued. If, however, its earnings multiple has risen to 30, then the position may be vulnerable.

No two positions are the same and even in these previous cases, the multiple may or may not be justified, but at the least, they require your attention and awareness of the potential exposure to a market rollback. While all stocks are hurt in a bubble burst, the ones flying highest are the most vulnerable because prices reflect expectations and bubbles at their heart are a bursting of expectations.

Intelligent Investors want to protect themselves from getting crushed when the inevitable happens and look for coping strategies, but how?

The answer is twofold; first awareness and second preparation. An old market adage holds that if something sounds too good to be true, it probably is. The market’s job is to reflect value. In a bubble, valuations don’t just reflect earnings potential for the next few years but sometimes the next few centuries. Hope and grandiose assumptions replace sober analysis.

Excessive and unrealistic valuations are always a concern. In addition to market analysis, investors should be looking at large institutional exposures. For example, today student loans now are nearly 1.2 trillion dollars. Collateralized Loan Obligations (CLO) are over 1.6 trillion.  And let’s not forget the Credit Default Swap market with exposure in the trillions.

A recession could trigger defaults on these debts with dramatic spill over effects to the equity markets. No one is certain where the next bubble will come from, but the threat is always present. The writing is clearly on the wall. Trouble is, it’s written in invisible ink.