5 Stages of a bubble
Looking at QCOM, AMZN, and CSCO in 1999, one might see Tesla as the new bubble. But what is a bubble and what are its stages?
Stock market bubbles involve equities—shares of stocks that rise rapidly in price, often out of proportion to their companies' fundamental value (their earnings, assets, etc.). These bubbles can include the overall stock market, exchange-traded funds (ETFs), or equities in a particular field or market sector—like Internet-based businesses, which fueled the dotcom bubble of the late 1990s.
1. Displacement
A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or historically low-interest rates. A classic example of displacement is the decline in the federal funds rate from 6.5% in July 2000, to 1.2% in June 2003.2 Over these three years, the interest rate on 30-year fixed-rate mortgages fell by 2.5 percentage points to a then-historic low of 5.23%, sowing the seeds for the subsequent housing bubble.3
2. Boom
Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be a once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of investors and traders into the fold.
3. Euphoria
During this phase, caution is thrown to the wind, as asset prices skyrocket. Valuations reach extreme levels during this phase as new valuation measures and metrics are touted to justify the relentless rise, and the "greater fool" theory—the idea that no matter how prices go, there will always be a market of buyers willing to pay more—plays out everywhere.
For example, at the peak of the Japanese real estate bubble in 1989, prime office space in Tokyo sold for as much as $139,000 per square foot.4 Similarly, at the height of the Internet bubble in March 2000, the combined value of all technology stocks on the Nasdaq was higher than the GDP of most nations.
4. Profit-Taking
In this phase, the smart money—heeding the warning signs that the bubble is about at its bursting point—starts selling positions and taking profits. But estimating the exact time when a bubble is due to collapse can be a difficult exercise because, as economist John Maynard Keynes put it, "the markets can stay irrational longer than you can stay solvent."
In Aug. 2007, for example, French bank BNP Paribas halted withdrawals from three investment funds with substantial exposure to U.S. subprime mortgages because it could not value its holdings. While this development initially rattled financial markets, it was brushed aside over the next couple of months, as global equity markets reached new highs. In retrospect, Paribas had the right idea, and this relatively minor event was indeed a warning sign of the turbulent times to come.
5. Panic
It only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot inflate again. In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate at any price. As supply overwhelms demand, asset prices slide sharply.
Source: urlshortner.org/lJpr4
Stock market bubbles involve equities—shares of stocks that rise rapidly in price, often out of proportion to their companies' fundamental value (their earnings, assets, etc.). These bubbles can include the overall stock market, exchange-traded funds (ETFs), or equities in a particular field or market sector—like Internet-based businesses, which fueled the dotcom bubble of the late 1990s.
1. Displacement
A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or historically low-interest rates. A classic example of displacement is the decline in the federal funds rate from 6.5% in July 2000, to 1.2% in June 2003.2 Over these three years, the interest rate on 30-year fixed-rate mortgages fell by 2.5 percentage points to a then-historic low of 5.23%, sowing the seeds for the subsequent housing bubble.3
2. Boom
Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be a once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of investors and traders into the fold.
3. Euphoria
During this phase, caution is thrown to the wind, as asset prices skyrocket. Valuations reach extreme levels during this phase as new valuation measures and metrics are touted to justify the relentless rise, and the "greater fool" theory—the idea that no matter how prices go, there will always be a market of buyers willing to pay more—plays out everywhere.
For example, at the peak of the Japanese real estate bubble in 1989, prime office space in Tokyo sold for as much as $139,000 per square foot.4 Similarly, at the height of the Internet bubble in March 2000, the combined value of all technology stocks on the Nasdaq was higher than the GDP of most nations.
4. Profit-Taking
In this phase, the smart money—heeding the warning signs that the bubble is about at its bursting point—starts selling positions and taking profits. But estimating the exact time when a bubble is due to collapse can be a difficult exercise because, as economist John Maynard Keynes put it, "the markets can stay irrational longer than you can stay solvent."
In Aug. 2007, for example, French bank BNP Paribas halted withdrawals from three investment funds with substantial exposure to U.S. subprime mortgages because it could not value its holdings. While this development initially rattled financial markets, it was brushed aside over the next couple of months, as global equity markets reached new highs. In retrospect, Paribas had the right idea, and this relatively minor event was indeed a warning sign of the turbulent times to come.
5. Panic
It only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot inflate again. In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate at any price. As supply overwhelms demand, asset prices slide sharply.
Source: urlshortner.org/lJpr4
Market Maven: Never Miss a Move.
Disclaimer: This is not a financial advice and all posts are for educational purposes only.
Disclaimer: This is not a financial advice and all posts are for educational purposes only.
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