Understanding market bubbles: The feather analogy of boom and busts

Picture this: you're standing atop a 50-storey building with a bag full of lightweight feathers, and a strong wind is blowing. You open the bag, letting the feathers fly in all directions. Some fall at your feet, some land a few meters away, and others travel far—perhaps even to another city.

Of course, it's impossible to predict exactly where each feather will land, but one thing is certain: every feather will eventually fall to the ground.

Let’s think of the feathers as stocks, the strong wind as the stock market, the distance they travel as share prices, and the ground as the fair value or replacement value of these stocks. It’s a compelling analogy to explain how stock prices move in relation to their intrinsic values.

Stock prices tend to trade either significantly above or below their intrinsic values, driven by the market’s positive or negative momentum. This can push prices marginally or significantly away from their true worth. In some cases, stocks can trade at a large premium to their intrinsic values and remain overvalued for a prolonged period.

However, much like gravity eventually pulls the feathers to the ground, market corrections—often through bear markets—pull stock prices back to their intrinsic values.

This insightful analogy was introduced by noted investor Jeremy Grantham, who used it to illustrate how stock prices deviate from their replacement or intrinsic values in varying degrees. He also pointed out that, just as feathers don’t land at the same pace, stock prices don’t always revert to their fair value with perfect timing. Sometimes they correct quickly, and sometimes they take longer.

In stock market terms, there is significant uncertainty regarding how long it will take for prices to return to their intrinsic values, and that’s the crux of the challenge. Grantham observed that most clients lack patience beyond three years. If stock prices don’t revert to their intrinsic values within that timeframe, investors may switch to another fund manager—precisely what happened to Grantham during the dot-com bubble. He noted that they lost up to 60% of their business in just two-and-a-half years because clients grew impatient.

The majority of Grantham's clients abandoned him because they didn’t like his warnings about a looming stock market bubble, particularly in tech stocks. They believed Grantham and his team were completely wrong, choosing instead to continue investing in high-growth stocks.

The good news, however, is that reality eventually asserts itself. Every stock or asset class has a replacement value, also known as its intrinsic value. While stock prices may deviate significantly from this value—and for extended periods—they ultimately work their way back to it.

As we now know, the tech bubble did indeed burst, and most stocks returned to their intrinsic values. For Grantham, though, the extended period of market irrationality came at a steep cost, with the loss of many clients. Fortunately, Grantham’s firm survived and emerged stronger.

To recap, markets become inefficient from time to time, with different stocks deviating in price from their true or intrinsic values. Sometimes these deviations are extreme, and stocks may not revert to fair value quickly. But, over time, they almost always do.

As an investor, your goal should be to invest in stocks trading significantly below their fair value and avoid those priced significantly higher. Following this simple rule can help you avoid much of the danger in the stock market and position you for strong long-term returns.

Happy Investing.

This article is syndicated from Equitymaster.com.