Stock market bubbles and Financial crises

Table of Contents

One of the perennial truths of financial history: Sooner or later, every bubble will burst. Sooner or later, bearish sellers outnumber the bullish buyers. Sooner or later, greed turns to fear.

So you think we might have put a few people out of business today. That its all for naught. You’ve been doing that everyday for almost forty years Sam. And if this is all for naught then so is everything out there. Its just money; its made up. Pieces of paper with pictures on it so we don’t have to kill each other just to get something to eat. It’s not wrong. And it’s certainly no different today than its ever been. 1637, 1797, 1819, 37, 57, 84, 1901, 07, 29, 1937, 1974, 1987-Jesus, didn’t that fucker up me up good-92, 97, 2000 and whatever we want to call this. It’s all just the same thing over and over; we can’t help ourselves. And you and I can’t control it, or stop it, or even slow it. Or even ever-so-slightly alter it. We just react. And we make a lot money if we get it right. And we get left by the side of the side of the road if we get it wrong. And there have always been and there always will be the same percentage of winners and losers. Happy foxes and sad sacks. Fat cats and starving dogs in this world. Yeah, there may be more of us today than there’s ever been. But the percentages-they stay exactly the same. - John Tuld, The movie “Margin call”.

Stock market bubbles

Bubble, in an economic context, generally refers to

a situation where the price for something - an individual stock, a financial asset, or even an entire sector, market, or asset class - exceeds its fundamental value by a large margin.

However, this rapid growth is relatively short-lived. And it abruptly reverses course, dragging asset prices down with it, sometimes even lower than their original levels.

e.g. the bursting of a bubble

Because speculative demand, rather than intrinsic worth, fuels the inflated prices, the bubble eventually but inevitably pops, and massive sell-offs cause prices to decline, often quite dramatically. In most cases, in fact, a speculative bubble is followed by a spectacular crash in the securities in question.

Economist Robert Shiller defined a bubble as a

situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases, and bringing in a larger and larger class of investors who, despite doubts about the real value of an investment, are drawn to it partly by envy of others’ successes and partly through a gamblers’ excitement.

In the four hundred years since shares were first bought and sold, there has been a succession of financial bubbles. Time and again, share prices have soared to unsustainable heights only to crash downwards again. Time and again, this process has been accompanied by skulduggery, as unscrupulous insiders have sought to profit at the expense of naive neophytes. So familiar is this pattern that it is possible to distil it into five stages:

Financial crises

Few things are harder to predict accurately than the timing and magnitude of financial crises, because the financial system is so genuinely complex and so many of the relationships within it are non-linear, even chaotic.

Causes

Typically, a bubble is created out of sound fundamentals, but eventually exuberant, irrational behavior takes over, and the surge is caused by speculation—buying for the sake of buying, in the hopes prices continue to rise.

https://www.investopedia.com/terms/f/fundamentals.asp

A basic characteristic of financial bubbles is the suspension of disbelief (or too much belief) by most participants when the speculative price surge is occurring: It’s only in retrospect, after the bubble has burst, that they’re recognized.

Irrational exuberance is the psychological basis of a speculative bubble, wrote economist Robert Shiller in his 2000 book, Irrational Exuberance.

Asset bubbles can begin in any number of ways, and often for sound reasons. Major incubators of bubbles, which often interact or occur in tandem, include:

  1. Interest rates might be low, which tends to encourage borrowing for spending, expansion, and investment.
  2. Low-interest rates and other favorable conditions in a nation encourage an influx of foreign investment and purchases.
  3. New products or technologies spur demand and, whenever something’s in demand, its price naturally rises (what the economists dub demand-pull inflation).
  4. There are shortages of an asset, causing the cost of it to climb—again, classic supply-and-demand principles.

So far, so good: These are all solid factors for appreciation. However, a problem arises when an asset bubble begins, snowball-like, to feed on itself—and to swell out of proportion to the fundamentals, or intrinsic worth, of the assets involved. Opportunistic investors and speculators are plunging in and pushing prices up even more.

https://www.investopedia.com/articles/investing/082515/how-do-asset-bubbles-cause-recessions.asp

Why are they doing this? It has to do not with fundamentals but with human foibles—psychological and often irrational thinking and actions about money, known as behavioral financial biases. These behaviors include things like:

https://www.investopedia.com/terms/b/behavioralfinance.asp

  1. Herd mentality: doing something because everyone else is
  2. Short-term thinking: just looking at the immediate returns, or thinking you can “beat the market” and time a quick exit
  3. Cognitive dissonance: only accepting information that confirms an already-held belief, and ignoring anything that doesn’t

Indicators

Trouble with bubbles is, they are hard to spot while we are in one. Only in hindsight, after they burst, do they become clear.

“A rapid price rise, high trading volume, and word-of-mouth spread are the hallmarks of typical bubbles,” says Timothy R. Burch, an Associate Professor of Finance at the Miami Herbert Business School. “If you learn of an investment opportunity with dreams of unusually high profits from social media or friends, be particularly wary—in most cases, you’ll need uncanny timing to come out ahead.”

Types

Theoretically, the types of asset bubbles can be infinite. Some recent examples include:

  1. cryptocurrencies like Bitcoin & Dogecoin to
  2. meme stocks like Gamestop & AMC
  3. housing prices
  4. tulip bulbs

Financial bubbles, aka asset bubbles or economic bubbles, fit into four basic categories:

  1. stock market bubbles,
  2. market bubbles - involve other industries or sections of the economy, outside of the equities market.
    1. Examples
      1. Real estate.
      2. Run-ups in currencies, either traditional ones like the US dollar or euro or cryptocurrencies like Bitcoin or Litecoin.
  3. credit bubbles - a sudden surge in consumer or business loans, debt instruments, and other forms of credit.
    1. Examples
      1. corporate bonds or government bonds (like US Treasuries)
      2. student loans
      3. mortgages
  4. commodity bubbles - increase in the price of traded commodities
    1. Examples
      1. gold
      2. oil
      3. industrial metals
      4. agricultural crops

Bubbles are deceptive and unpredictable, but understanding the five stages they characteristically go through can help investors prepare for them.

Stages and recurrent features

  1. Displacement: Some change in economic circumstances creates new and profitable opportunities for certain companies.
  2. Euphoria or overtrading: A feedback process sets in whereby rising expected profits lead to rapid growth in share prices.
  3. Mania or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money.
  4. Distress: The insiders discern that expected profits cannot possibly justify the now exorbitant price of the shares and begin to take profits by selling.
  5. Revulsion or discredit: As share prices fall, the outsiders all stampede for the exits, causing the bubble to burst altogether.

Stock market bubbles have three other recurrent features.

  1. The first is the role of what is sometimes referred to as asymmetric information. Insiders - those concerned with the management of bubble companies - know much more than the outsiders, whom the insiders want to part from their money. Such asymmetries always exist in business, of course, but in a bubble the insiders exploit them fraudulently.
  2. The second theme is the role of cross-border capital flows. Bubbles are more likely to occur when capital flows freely from country to country. The seasoned speculator, based in a major financial centre, may lack the inside knowledge of the true insider. But he is much more likely to get his timing right - buying early and selling before the bubble bursts than the naive first-time investor. In a bubble, in other words, not everyone is irrational; or, at least, some of the exuberant are less irrational than others.
  3. Finally, and most importantly, without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission or commission of central banks.

The five stages in the lifecycle of a bubble

Some economists have identified five stages of a bubble - a pattern to its rise and fall - that could prevent the unwary from getting caught in its deceptive clutches.

Economist Hyman P. Minsky was one of the first to explain the development of financial instability and the relationship it has with the economy. In his pioneering book Stabilizing an Unstable Economy (1986), he identified five stages in a typical credit cycle, one of several recurrent economic cycles.

  1. displacement
  2. boom
  3. euphoria
  4. profit-taking and
  5. panic

1. Displacement

A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low. 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. Over this three-year period, 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.

  1. https://www.investopedia.com/terms/n/newparadigm.asp
  2. https://www.investopedia.com/terms/f/federalfundsrate.asp

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.

  1. https://www.investopedia.com/terms/m/momentum.asp

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. 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.

  1. https://www.investopedia.com/terms/m/metrics.asp
  2. https://www.investopedia.com/terms/g/greaterfooltheory.asp
  3. https://www.investopedia.com/terms/i/internet-bubble.asp
  4. https://www.investopedia.com/terms/n/nasdaq.asp

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.

  1. https://www.investopedia.com/terms/s/smart-money.asp
  2. https://www.investopedia.com/terms/j/john_maynard_keynes.asp

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.

One of the most vivid examples of global panic in financial markets occurred in Oct. 2008, weeks after Lehman Brothers declared bankruptcy and Fannie Mae, Freddie Mac, and AIG almost collapsed. The S&P 500 plunged almost 17% that month, its ninth-worst monthly performance.

  1. https://www.investopedia.com/terms/m/margincall.asp
  2. https://www.investopedia.com/terms/l/lehman-brothers.asp

After effects

A range of things can happen when an asset bubble finally bursts, as it always does, eventually. Sometimes, the effect can be small, causing losses to only a few, and/or short-lived. At other times, it can trigger a stock market crash, a general economic recession, or even depression. It is also possible to have a temporary rebound, known as an echo bubble.

https://www.investopedia.com/terms/e/echobubble.asp

Much depends on how big the bubble is—whether it involves a relatively small or specialized asset class vs. a significant sector like, say, tech stocks or residential real estate. And, of course, how much investment money is involved.

Another factor is to what degree debt is involved in inflating the bubble. A major 2015 research study, “Leveraged Bubbles,” examined asset bubbles in 17 countries dating back to the 1870s. It categorized them into four types, but along two basic lines, based on credit—that is, how funded investments were by financing and borrowing.

http://conference.nber.org/confer/2015/EASE15/Jorda_Schularick_Taylor.pdf

The study found that the more credit involved, the more damaging the bubble’s pop. Debt-fueled equity bubbles led to longer-lived recessions. Even worse were leveraged housing bubbles, like the one that popped in 2006-07, leading to the subprime mortgage crisis that kicked off the Great Recession.

  1. https://www.investopedia.com/articles/07/subprime-blame.asp
  2. https://www.investopedia.com/terms/g/great-recession.asp

Damages caused by them

The damage caused by the bursting of a bubble depends on the economic sector (s) involved, whether the extent of participation is widespread or localized, and to what extent debt fueled the investments that inflated the bubble.

They lead to prolonged periods of stagnation for the economy and severe recessions.

Stock market and market bubbles, in particular, can lead to a more general economic bubble, in which a regional or national economy overall inflates at a dangerously fast clip.

Examples

  1. The bursting of the equity and real estate bubbles in Japan in 1989–1992 led to a prolonged period of stagnation for the Japanese economy—so long that the 1990s are referred to as the Lost Decade.
  2. Tulipmania describes the first major financial bubble, which took place in 17th-century Holland: Prices for tulips soared beyond reason, then fell as fast as the flower’s petals.
    1. https://www.investopedia.com/terms/d/dutch_tulip_bulb_market_bubble.asp
  3. In the U.S., the burst of the dotcom bubble in 2000. It occurred around the turn of the 21st century. It was a rapid rise in U.S. technology stocks, especially those in then-novel Internet-based companies, that helped lift the stock markets in general. The tech-dominated Nasdaq index quintupled in value, from under 1,000 to more than 5,000 between 1995 and 2000.
    1. Unfortunately, when many of the new, hot tech companies failed to turn a profit or perform up to expectations, investors soured on them. In 2001-02, the bubble popped. In the ensuing crash, the Nasdaq index fell over 75%. Stocks in general entered a bear market.
  4. In the U.S., the residential real estate bubble in 2008
    1. The housing bubble and the financial crisis of 2008
  5. The Roaring Twenties and The Great Depression of 1929

References

https://www.investopedia.com/articles/stocks/10/5-steps-of-a-bubble.asp

TODO

  1. Ray Dalio’s Surprising Advice for Surviving Market Crashes: https://www.investopedia.com/ray-dalio-on-surviving-market-crashes-11699830
  2. Warren Buffett’s Advice on What To Do When the Stock Market Crashes: https://www.investopedia.com/warren-buffett-on-stock-market-crashes-11693767

Tags

  1. The man who invented the stock market bubble
  2. Enron scandal

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