Stock market bubbles are events driven by investor speculation. Because they can generate and destroy tremendous amounts of wealth, stock market bubbles can seriously affect the length of time it takes for you to reach financial independence. Being able to navigate through a stock market bubble is important; and to do this, we first need to understand the stages of bubble.
Stages of a bubble
All stock market bubbles follow a similar pattern which can be talked about in 5 stages: displacement, boom, euphoria, profit taking and panic. To illustrate how prices move during a bubble I’m going to use the NASDAQ index from 1994 through to 2004. This period is commonly referred to as the Dotcom bubble.
Displacement
A change in investor sentiment towards a particular asset or asset class occurs. It often coincides with the introduction of an innovation such as railroads; the internet; or cryptocurrency. During this time early investors, such as venture capitalists, finance the new innovation hoping to reap the rewards derived from the asset’s fundamental benefits. In the case of the Dot Com bubble this period was signified by the release of web browsers in 1993 that gave users access to the internet.
Boom
The investment opportunity becomes widespread among the investment community and begins to attract speculators. This stage is where price growth really starts to pick up – I like to think of it as steadily inflating the bubble.
Euphoria
During the ‘euphoria’ stage asset prices grow very quickly. Price growth reaches a point where the they become disconnected from rational valuations. Because so many overconfident investors are keen to enter the market a feeling that it is impossible to lose money perpetuates the growth cycle.
In the late 1990s investors were buying any company that had an internet related suffix, almost regardless of the prospects or strength of their business model. By 1999, 39% of all venture capital funds were going towards internet companies (Hayes 2019)
Profit taking
After a certain duration of massive price increases, investors begin to question how sustainable price growth is. Investors begin selling their holdings to lock in profits. During this stage some speculators will hold on hoping that the prices will go back up.
In the case of the dot com bubble tech companies such as Dell placed large sell orders on their stocks (Hayes 2019) and some entrepreneurs sold performed hedging activities to protect their gains.
Panic
Once the broader market recognizes that asset prices are falling quickly panic selling occurs. This behavior results in widespread losses and perpetuates further panic selling.
With the stream of cheap and easy money flowing into capital markets essentially ceased, the year 2000 saw the US federal reserve raise interest rates. The NASDAQ index declined over 70% in the subsequent years.
How to spot a stock market bubble
Because stock market valuations are based on future earnings it is very difficult to tell if a bubble has formed for a particular asset or asset class. If investor expectation turns out to be true, then rapid price rises may not precede a crash. Nevertheless, stock market bubbles tend to feature certain elements that greatly increase the risk of a rapid collapse in asset prices.
Excessively high valuations
During the Dotcom bubble the NASDAQ composite index reached a P/E ratio of around 175 (Long 2015), which means investors were paying $175 for every dollar of earnings. When you compare such a figure to the historic average market PE which sits around 15 times earnings it indicates that the market appetite for risk was extremely high. High valuations imply high expectations for future earnings, which increases the probability that a company/asset will fall short of these expectations and subsequently experience a devaluation.
Overconfident speculation
A situation where ‘investors’ are buying assets simply because they believe they are ‘guaranteed’ to appreciate implies an environment of extreme overconfidence. This type of behavior causes asset prices to become disconnected from their fundamentals which increases the risk of a correction.
Investing decisions based purely on extrapolating trends is another common feature of overconfident speculation. Simply because an asset had doubled/tripled its value in one year is no guarantee that it will so the following year.
Public investment
The displacement and the early boom phase of a bubble tend to be dominated by professional investors who are better equipped to deal with risk than the general public. However, as the price growth becomes more well known, the public, becomes heavily involved in speculation. When you combine this with overconfidence and the inability to manage risk a dangerous situation can take place.
Debt fueled activity
Debt increases the volatility of asset prices, especially when panic selling begins. This is because an investor carrying debt on a loss-making asset faces more pressure to sell than one which is unlevered. Further to this, if demand for the asset is largely fueled by debt, then an increase in the interest rate will decrease demand which causes the price of the asset to fall.
Conclusion
Stock market bubbles tend to follow the stages referred to as: displacement, boom, euphoria, profit taking and panic. While it is difficult to determine with high degree of certainty if a stock market bubble is occurring. It’s still worthwhile trying to determine whether the market is experiencing euphoria. When price becomes detached from fundamental valuation, downside risk outweighs upside potential, which implies that any investing needs to be done with caution. In the next post I’m going to discuss why investing in a bubble is worthwhile and how to manage your finances to increase your chances of surviving the correction.
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References
Yahoo finance, 2021, NASDAQ Composite (^IXIC) Adj close 1/1/1992 to 1/12/2004 (Monthly), Yahoo finance, available from: <https://au.finance.yahoo.com/quote/%5EIXIC/history?period1=694224000&period2=1072915200&interval=1mo&filter=history&frequency=1mo&includeAdjustedClose=true>
Jackson, A-L., Schmit J.,2021, Blowing Bubbles: What Is A Stock Market Bubble?, Forbes Advisor, available from: <https://www.forbes.com/advisor/investing/stock-market-bubble/>
Segal, T., 2021, 5 Stages of a Bubble, Investopedia, available from: <https://www.investopedia.com/articles/stocks/10/5-steps-of-a-bubble.asp>
Hayes, A, 2019, Dotcom Bubble, Investopedia, available from: <https://www.investopedia.com/terms/d/dotcom-bubble.asp>
Long, H., 2015, Tech stocks aren’t at bubble levels, CNN Business, available from: <https://money.cnn.com/2015/03/10/investing/nasdaq-5000-stocks-market/index.html>