First, in finance, the concept of a bubble is theory. This means not everyone believes bubbles exist. For those who do believe, bubbles can exist in securities, commodities, industries, housing markets – just about anywhere investors place value on something.
Simply put, a bubble is an overheated market with too many buyers. Prices go up too fast and eventually the situation becomes unsustainable. At some point people begin to realize what is going on and start selling. This eventually leads to panic selling, prices plunge and people who entered late lose a lot of money.
Related: ACTIVE TRADING METHODS
In the late 1990s and early 2000s technology was the darling of Wall Street. People began to believe prices for tech stocks would keep rising as new customers signed up. In the end, investors lost confidence and a sell-off took place leading to a market correction. When the dotcom bubble burst many investors held stocks that were worthless, and many companies went bankrupt.
A Contrary View
The efficient market theory (EMH) says bubbles don’t really exist. EMH proponents believe market efficiency forces asset prices to reflect their true economic value, mostly based on the notion that everything that can be known, is known. According to EMH, a bubble is nothing more than a change in the fundamental expectations about an asset’s returns. Even if bubbles did exist – according to EMH theorists – they can’t be predicted because investors are rational and would not buy into a bubble if its overvaluations were known and identifiable.
5 Stages Of A Bubble
Economist Hyman Minsky identified five stages in a typical credit cycle – displacement, boom, euphoria, profit taking and panic. Displacement is when investors fall in love with a new paradigm such as an innovative new technology. It can also occur when interest rates are historically low. Displacement is followed by boom in which prices rise slowly at first and then gain momentum. Euphoria follows when asset prices skyrocket, and everyone wants “in” on the new investment. Profit taking (by smart investors) precipitates full-blown panic. Knowing when to take profit is more art than science and the reason so many investors fall prey to the panic phase.
There are voices in the market claiming increasing signs of euphoria (step 3 in the bubble cycle). If so, investors need to position themselves to make money – not lose money. The question becomes – how to play a euphoric market? Up to now, since the last crisis, the market has been growing steadily. Investors have been cautious with shareholders pressing CEOs to return cash rather than boost capital spending. Enter the “greater fool” theory. This is when investors become ultra-bullish, buy overvalued stocks and hope to sell them to the “greater fool” or an investor less savvy than they are.
Related: UNDERSTANDING PENNY STOCKS
Despite the signs of euphoria, many experts are saying it’s too soon to call this a bubble. Equities are expensive, but interest rates and bond yields are depressed – suggesting low returns ahead and not euphoria. All this leads to speculation that there may be a year or two of gains approaching 35% (according to one analyst).
The problem is timing the exit. Four feasible options are – get out early and don’t worry about feeling left out; get out late but be ready to sell quick; stay in but be cautious and stick with high-quality companies; and look elsewhere, i.e., emerging-market stocks that could do well if the U.S. bubble bursts.