Euphoria Revisited: Lessons from Galbraith in Today’s Market

Written by Diego Hinojosa 

November 26, 2024  

In the wake of the “Trump Trade,” I have grappled with explaining the market’s recent movements. Much like seeking wisdom from sacred texts in uncertain times, I have turned to John Kenneth Galbraith’s A Short History of Financial Euphoria for guidance. Though concise, the book provides a powerful historical lens to examine the cyclical nature of financial bubbles, suggesting that today’s patterns echo those of the past.

Galbraith’s analysis spans centuries, from the Dutch Tulip Mania of the 17th century to the 1987 market crash. He identifies recurring themes that often precede financial crises, such as:

Excessive leverage tied to innovative financial instruments;

A speculative asset class;

Lax regulatory oversight;

Speculators wielding political influence;

A short public memory of previous crashes;

A collective belief that prices will rise indefinitely.

By exploring each of these elements, we can better understand their relevance to the current financial landscape.

Leverage: The Growth of Private Credit and Its Role in Buyouts

The rapid growth of private credit markets is a modern embodiment of Galbraith’s leverage concerns. Private credit—where non-bank entities lend directly to companies—has ballooned to over $2.1 trillion globally as of 2023, with the U.S. commanding the lion’s share. This growth is fueled by its flexibility and higher yields compared to traditional bank lending, albeit with a trade-off in illiquidity.

Private credit has increasingly been used to finance leveraged buyouts (LBOs), drawing parallels to the M&A boom of the 1980s. As Galbraith noted, the LBO frenzy of that era was powered by excessive leverage, often funded through high-yield junk bonds. This debt-fueled buying spree allowed companies to finance acquisitions with borrowed money, creating the perception of growth while masking underlying financial vulnerabilities. When the deals failed to generate sufficient returns, the resulting defaults highlighted the dangers of speculative leverage.

Galbraith also warned of the illusion of innovation, where financial tools tied to leverage are often presented as transformative breakthroughs during speculative booms. In the 1980s, junk bonds were touted as democratizing access to capital and driving entrepreneurial growth. Today, private credit products are similarly marketed as flexible solutions that enhance financial efficiency. However, these innovations can obscure the systemic risks they introduce, particularly when used to fund speculative buyouts or acquisitions.

In an effort to increase accessibility and liquidity, private credit has also given rise to exchange-traded funds (ETFs) that bundle private loans into tradable securities. This mirrors the structured financial products like collateralized mortgage obligations (CMOs) that gained popularity in the lead-up to the 2008 financial crisis. While these products promise liquidity, they often obscure the risks inherent to the underlying assets, including illiquidity and potential defaults. Such attempts to transform inherently illiquid private credit into "liquid" instruments echo past financial innovations that contributed to systemic instability.

The lessons from the 1980s LBO boom and the 2008 financial crisis remain pertinent: when leverage becomes excessive and speculative, and when illiquid assets are repackaged as liquid products, the fragility of the financial system grows. As private credit fuels modern buyout activity, it raises the question of whether history is repeating itself under a different guise.

Speculative Assets and Market Trends

Galbraith’s discussion of speculative assets resonates today with phenomena like Bitcoin and the AI boom. Much like the Dutch Tulip Mania, where in 1636 a rare Semper Augustus tulip bulb could be worth around 3,000 florins—equivalent to an unimaginable $25,000 to $50,000 today—Bitcoin’s volatile price movements highlight the risks of assets detached from intrinsic value. With Bitcoin recently reaching prices comparable to those inflated valuations, the parallels are striking: both represent speculative fervor driven by the belief that prices will only go higher.

Another historical parallel can be drawn to the South Sea Bubble of 1720. The South Sea Company captivated investors with promises of untold riches from trade opportunities in South America. Despite limited tangible operations or profits, the company's shares soared to extraordinary heights before collapsing, wiping out fortunes. The bubble was fueled by grand narratives, speculative fervor, and widespread belief in the “new opportunity” it presented—echoing today’s speculative enthusiasm for Bitcoin and the AI sector.

The Mississippi Bubble of the same era shares similar characteristics. French economist John Law established the Mississippi Company, tying its success to the economic promise of Louisiana’s untapped resources. Through aggressive marketing and promises of immense profits, the company’s stock price skyrocketed as speculative mania took hold. Investors poured money into what seemed like a once-in-a-lifetime opportunity, believing Law’s vision of wealth was inevitable. However, like the South Sea Bubble, this optimism unraveled when the company’s actual profits fell far short of expectations. The collapse devastated France’s economy and serves as another reminder of the dangers of speculation untethered from reality.

Similarly, the AI sector bears a resemblance to the dot-com bubble of the late 1990s. During that period, speculative hype centered on internet companies, many of which generated little to no revenue but commanded sky-high valuations based on promises of future growth. Today, the AI boom differs in that many leading companies are profitable and generate substantial cash flow. However, the market remains heavily concentrated in a small number of these firms, driving their valuations to potentially unsustainable levels. While the fundamentals of AI leaders are stronger than those of dot-com startups, the concentration and optimism surrounding the sector evoke familiar risks.

Lax Regulatory Oversight

Under the Trump administration, regulatory changes altered the market landscape. Looser oversight of regional banks, cryptocurrencies, and mergers has fueled expectations of increased lending and market activity. However, critics argue that such deregulation heightens systemic risks.

A historical parallel can be found in the 1920s, as described by Galbraith. During this era, financiers often criticized the Federal Reserve’s early efforts at intervention and the central bank’s attempts to restrict credit. These calls for minimal regulation eventually led to a hands-off approach, creating fertile ground for speculative excesses. The result was a series of bubbles in the stock market and real estate, culminating in the 1929 crash and the Great Depression. Once the central bank's influence waned, unchecked speculation took hold, with devastating consequences.

For example, the real estate bubble of the 1920s—particularly in Florida—was fueled by easy credit and rampant speculation. Investors believed that property values would continue to rise indefinitely, with some purchasing land sight unseen. Similarly, the stock market bubble of the same period saw massive inflows of speculative capital, often on margin, as investors chased seemingly limitless profits. The eventual collapse underscored the dangers of deregulation and unbridled speculation.

This history resonates with modern debates about the Federal Reserve’s role. Trump frequently voiced frustration with Fed Chair Jerome Powell, blaming him for not lowering interest rates fast enough to stimulate growth. While openly suggesting firing Powell, Trump also signaled broader discontent with regulatory oversight, which he viewed as a constraint on economic expansion. Such tensions between political leaders and central banks often presage a more hands-off approach to financial markets—potentially setting the stage for speculative bubbles.

Short Public Memory of Previous Crashes

The swift recovery from the pandemic-induced crash reflects the diminishing memory of financial crises. Many investors today lack firsthand experience with significant downturns like the 2008 financial crisis. The rise of trading platforms with easy access—designed like slot machines and offering leverage and margin—has further encouraged risk-taking among younger investors.

This dynamic resembles the speculative fervor of the 1920s, when brokers provided margin loans to stock investors, enabling them to buy stocks with as little as 10% of the purchase price upfront. The availability of margin created a self-reinforcing cycle: rising stock prices led to greater borrowing, which further inflated prices—until the bubble inevitably burst. Similarly, today’s trading platforms offer retail investors access to leveraged positions, increasing their exposure to market volatility and amplifying risks.

I was surprised when my 14-year-old son recently told me about a friend who had opened a trading account and was betting everything on a single stock, using $2,000 on margin—without his father even knowing. Concerned about the risks he was taking without understanding the potential consequences, the most I could do to try to help was to give him a copy of Joel Greenblatt’s The Little Book That Beats the Market as a birthday present. If he’s already on margin, let’s at least hope he diversifies.

The Collective Belief That Prices Will Rise Indefinitely

Warren Buffett’s favored market indicator, the Wilshire 5000-to-GDP ratio, starkly highlights today’s overvaluation. This ratio compares the total market value of all publicly traded U.S. stocks, as measured by the Wilshire 5000 index, to the country’s GDP—the total value of goods and services produced in the economy. A high ratio suggests that the stock market is overvalued relative to the economy's size, while a lower ratio indicates undervaluation.

Historically, this ratio has averaged 75%. Today, however, it exceeds 200%, dwarfing even the peak of 130% during the 2008 crisis. This deviation strongly signals a market priced for perfection, with little room for error.

Despite these warning signs, optimism among investors remains unwavering. Many argue that strong corporate earnings and economic growth will sustain market returns. This sentiment is epitomized by a recent headline from Barron’s: “The Market is Extremely Expensive, Don’t Sell Your Stocks!”

Unchecked optimism often blinds investors to underlying risks. History teaches us that the moments of greatest exuberance are frequently precursors to sharp corrections. Yet, as Galbraith notes, speculative bubbles persist because each new cycle convinces participants that "this time is different."

Predictions of Bitcoin reaching $100,000 or beyond illustrate this speculative mindset. Such optimism often ignores underlying risks, perpetuating a cycle of short-term gains and long-term instability.

How Can We Invest in the Current Environment?

It’s often said on Wall Street that bubbles are difficult to time, but defending against them is not as challenging. Howard Marks offers a valuable analogy in his writings on risk management. He compares managing risk in a portfolio to soccer, where both defense and offense play simultaneously, unlike American football, where specialization separates the two. In investing, this means finding a balance between protecting your portfolio and pursuing opportunities.

Here are three key approaches to consider:

Keep Dry Powder
During periods where bargains are scarce, it can be prudent to hold a substantial portion of your portfolio in risk-free Treasury bills or other highly liquid, low-risk assets. This may not be the most exciting approach, but patience and discipline often lead to better opportunities down the line.

Focus on Defensive Stocks
Take a cue from Peter Lynch, who, contrary to what most people thought, rarely allocated more than 30–40% of his portfolio to growth stocks. Instead, he diversified his investments across cyclical companies, turnarounds, and dividend-paying stalwarts—stocks that he referred to as “defensive” due to their resilience in uncertain markets. Emphasizing such stocks can provide stability while still offering steady returns.

Avoid the Braggers and FOMO

In euphoric markets, there’s always someone boasting about their latest winning stock or their uncanny ability to “predict” the market. These braggers tend to share their successes while conveniently ignoring their losses, creating the illusion of easy profits. Their stories can stoke fear of missing out (FOMO), making you want to join the party and chase speculative opportunities. However, chasing the crowd rarely ends well in speculative bubbles. Instead, remind yourself that long-term wealth is built on discipline, not hype, and stick to your investing principles. After all, history teaches us that fools are often the last ones to buy into the “great ideas” of speculative manias.

Conclusion: Lessons from Galbraith

Galbraith’s insights remind us that financial euphoria is both timeless and recurrent. As markets continue their upward trajectory, today’s speculative behaviors bear striking similarities to past bubbles. While optimism drives markets in the short term, history warns of the risks of unchecked exuberance.

By understanding these patterns and applying prudent investment strategies, you can navigate these turbulent times. Whether it’s keeping dry powder, focusing on defensive stocks, or avoiding following the crowd, maintaining discipline and a long-term perspective is critical. As the lessons of past bubbles show, skepticism and caution are often more valuable than the allure of quick gains.