How Bubbles Affect The Stock Market

Note from The Money Marketer: This is a guest post by Financial Freedom 101 – be sure to check out their blog by clicking here. They provide lots of educational content on the stock market, perfect for the Gen-Z investor!

Stock market bubbles are common, and I think we are in one today. Bubbles form in economies, stock markets, and business sectors like the tech bubble that lasted from 1995-2001. Many people believe that we are going through another tech bubble right now, because of all the stock buy-backs and federal stimulus pumps that are making the assets in the market very high. Investors are valuing companies like uber at a multiple of 100 times its sales. To put that into perspective, Zipcar, the hot sharing-economy startup of its day, commanded around a 6x multiple at its peak. Microsoft fetched a similar one when it went public in 1986, achieving a market cap of $778 million on its first day out. Enterprise software firm, Slack is valued more than 90x its sales. There is a bubble going on right now, but the fed can’t stop printing money, and these big American corporations got a surreal amount of money with companies like Apple, who have 207 billion dollars on hand. 

How are bubbles formed

 Bubbles are formed by GREED. Economists define bubbles as a rapid escalation of stock prices followed by a contraction of greedy people who keep buying stocks blindly, not caring about the cost or risk presented, followed by a rapid market decline. 

 Often the first stage of a bubble is when a new product or technology is made public on the market and gets a lot of the public attention. Hence, then people dump an absurd amount of money into these companies blindly taking risk into account. As more and more investors enter the market, thinking that they too can profit from the run-up, inventory becomes scarce. As a result, prices rise at an extreme level, then fall to the floor. 

Causes Of An Asset Bubble

Three main things contribute to asset inflation.

  • Low-interest rates

The current economy in America has 0 interest rates, which SCREAMS that we are currently in a bubble. Low-interest rates make it easy to borrow money cheaply, which boosts investment spending. Historical evidence suggests that low-interest rates lead to asset bubbles and that investors take excessive risks to achieve desired investment returns, exposing their portfolios to a higher overall risk. Stock prices are already inflated, and the rise of the private credit market spells of trouble ahead.

  • Global Imbalances

Back when the tech bubble popped, many other countries like japan were investing in US assets. People believe that the inflow of currency from abroad was one of the leading reasons for the tech bubble. The US ran a trade deficit and attracted hot money inflows, leading to higher demand for US securities. The global imbalances are one of the causes of the 2008 financial and economic crisis. The financial flows associated to these imbalances in the international financial markets, which are incapable of absorbing efficiently these huge capital inflows.

  • High Trading Volume and High Volatility

During a bubble an asset buyer is willing to pay a price above fundamentals because, the buyer is afraid of missing out on the gains of a bubble so they buy an asset blindly at a overvalued price due to investor overconfidence. E*TRADE, Fidelity, Schwab, Robinhood, and Interactive Brokers all reported either increased activity, new account signups, or both, as individual investors adjusted their portfolios or bought equities and options at a rapid pace since March of 2020. Trading activity has soared to all time highs at many online brokers. Charles Schwab’s first-quarter financial reports showed that the top 30 volume days in the company’s history, 27 of them were set in February and March 2020. Logins by Fidelity clients increased by 56% from march 2019 to march 2020.

Five Stages Of A Financial Bubble

We can identify financial bubbles is the suspension of disbelief by most investors when the speculative price surge is occurring: It’s only in retrospect, after the bubble has burst, that they’re recognized. We can only ever Identify bubbles in hindsight and to make the right decisions to prepare.

  • Displacement

A displacement occurs when investors get infatuated by a new industry paradigm, such as new technology or interest rates that are historically low. A perfect example of displacement is back in 2000-2003when federal interest rates went from 6.5% to 1%. Over these three years the interest rate on 30-year fixed-rate mortgages fell by 2.5 percentage points to a historic lows of 5.21%, which was just the beginning phase for the housing bubble.

  • Boom

Prices rise slowly at first, following a displacement, but then gain significant momentum as more and more participants enter the market having FOMO. During this phase, the asset in attracts wide spread media coverage, like Electric Cars right now. FOMO is what could be an once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of participants into the fold, which then get burned when the bubble pops.

  • Euphoria

During this phase investors are pouring in large amounts of money into the market which causes prices to skyrocket. Valuations reach all time highs. Right now a lot of investors are coming into the market thinking its easy, anything bought within the last two months has gone up an absurd amount. Airlines,Cruise companies and even rental car companies are on the brink of collapse and people are still buying there stocks days after bankruptcy. this is the kind of stuff that happens during this phase of euphoria. Skill, strategy and money management don’t exist. It’s just about everything going up, all the time. And it’s not going to end well. The saying “Stonks only go up” has came out of this time of euphoria. Euphoria is usually the stage of a “False Bull Market” or a “Dead Cat Bounce” Personally, i think we are in this stage right now and its only a matter of time for the market to pop.

  • Profit Taking

In this phase, the smart money takes profit which is a huge warning sign that the market is going to burst. This is the best time to start selling positions and taking profit. Estimating the time a bubble collapse is hard but if your happy with the profits you have made take profit hold cash. Cash is a position and an opportunity will come, the market isn’t going to go up forever. It only takes a minor event to pop and bubble like covid-19. If we see another resurface of cases killing thousands of people the market will likely fall again because the Federal Mandate cant keep printing and putting money into the market.

  • Burst

In the Burst stage reality sets in, investors panic sell and prices drop at rapid rates. Prices ultimately fall faster then increase from previous weeks. Investors and speculators, faced plunging values of their holdings, now want to liquidate them at any price. As supply overwhelms demand, asset prices slide sharply and prices fall. An example of a burst is when 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. In that single month, global equity markets lost a staggering $9.3 trillion of 22% of their combined market capitalization. At this stage of the bubble people knew they were doomed and an economic recovery was far to come until the giant 10 year bull market we are experiencing right now.

Bubbles affect the stock market in many ways. Some can make millions off a stock market bubble and some could lose there whole life savings, its the matter of how you play the bubble. Speculative bubbles in some asset or the other are inevitable in a free-market economy. However, becoming familiar with the steps involved in bubble formation may help you to spot the next one and taking profit early. Remember, cash is a position and don’t be afraid to use it to your benefit, BUY LOW SELL HIGH.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: