How To Spot And Navigate A Market Bubble

Over the past few years, one of the more complex and unpredictable aspects of investing, particularly for a proprietary trading firm that is carefully investing its own capital, is the emergence of financial bubbles.

As people who made careful investments in Uranium in the mid-2000s, housing-related securities before 2007 and technology and online companies at the turn of the millennium can attest to, there is the opportunity to make considerable amounts of money.

However, with that potential reward comes an extreme level of risk and the potential for widespread negative consequences that can in some cases affect entire markets for decades and cause the downfall of institutions.

Why do market bubbles happen, how do we spot them, why do typically rational actors invest in otherwise unacceptably risky investments and what should investors do when they find that a field they invest in has entered a bubble phase?

This article aims to try and explore the theory, the history and some common aspects of speculative bubbles to help traders navigate environments where every rule of economics seems to have been broken.

 

What Is A Market Bubble?

Hand holding a needle ready to burst a Stock market bubble

An economic bubble, also known as a market bubble or a financial bubble, is a period of rapid escalation of asset prices, often to the point where these prices exceed any reasonable valuation.

This is then followed by a sudden, often calamitous descent in prices once the bubble bursts and people try to get their money out of the asset.

The concept had its origins in the infamous Dutch Tulip Mania of the 17th century, where speculation caused tulip bulbs to exponentially increase in price based on the idea that the demand (fuelled by people trying to make money from others) would never stop.

The term bubble itself, named for an economic bubble’s fragility, vast inflation based on no solid basis, and propensity to suddenly burst, often without warning, is named after the British South Sea Bubble, which is believed to be the first financial crisis as economists would recognise them today.

There are two major kinds of bubbles, based on the type of investment being made and the basis on which the market confidence emerged.

The first is the equity bubble, which is often based on an exaggeration of the value of a real, tangible asset and an admirable but overblown sense of optimism.

The many different cryptocurrency bubbles are an excellent recent example of an equity bubble, as whilst people purchasing blockchain-based assets are purchasing something technically tangible, the disconnect between the speculated value and its intrinsic value has led to some of the largest financial collapses in history.

Another major example besides tulip mania was the dotcom bubble. Whilst internet-based businesses would indeed change the world, the rush from both investors and startup companies alike led to a lot of investments in companies lacking solid fundamentals, a product or even a business plan, leading to an inevitable crash.

The other major type of bubble is the debt bubble, which tends to emerge from credit-based investments not backed by any real assets nor an existent market for which demand has surged. These include debt instruments, government bonds and other assets based on loans and other forms of credit.

The best example of this is the mortgage-backed security that led to a bubble in the United States housing market. In theory, if homeowners paid on time and banks kept reasonable standards for avoiding mortgage defaults, an MBS would keep providing bond payments to the investor who bought them.

However, as was seen in 2007, an MBS backed predominantly with subprime mortgages would be more prone to failing, making them overvalued, shaking the confidence of the asset as a whole and causing a fundamental collapse of the market with ramifications still felt to this day.

 

How Do You Spot A Bubble?

At its core, a bubble is simply the unsustainable soaring of an asset’s price compared to its intrinsic worth, although as many trading firms, financial analysts and day traders have different ways of calculating and determining said value, the concept is more subjective than it sounds.

Spotting a bubble can be difficult, and many investors know someone who has been caught out by a bubble that burst before they could get out.

It is complicated by a few factors, chief among which is that given how many types of bubbles there are, not all of them will behave the same.

A technology-based bubble, for example, will appear to be a legitimate spike in growth for quite a long time. Some epochal technologies may be that valuable or only slightly overvalued, whilst others will form a financial bubble, and in those cases, the penny will drop for everyone at the same time the stock price does.

As well as this, bubbles are often examples of behavioural finance, where asset prices are set by human behaviour rather than any fundamental concepts underpinning that value.

However, despite the differences between the Japanese asset bubble of the 1980s that precipitated the Lost Decade and the crypto boom and bust of the early 2020s, there are common trends that tend to suggest less of a bull market and more of a bubble.

One aspect is simply that such an investment or asset class becomes a national obsession, bringing in people who do not typically invest in that field, or perhaps do not invest at all.

A fluffy example of this was one of the most famous tulip manias of recent years in the Beanie Babies bubble. Due to the unusual way the Ty Corporation marketed and sold the plush toys, certain designs attracted a gigantic secondary market, ending in 1999 alongside the original run of the bears.

At its peak it was an international phenomenon, regularly reported in the news, alongside stories such as a divorce settlement involving a couple dividing a pile of the bears between them on the courtroom floor.

The next aspect is that there must be a new paradigm involved that shifts existing beliefs and ways of thinking.

This does not have to be a new product or technology, although often this can cause a new paradigm as was seen most infamously with the dotcom bubble.

It instead is a shift in the market that opens up space for some somewhat hyperbolic claims.

There is often enough evidence of potential at an early stage, but where it becomes a bubble is when this seed fails to grow the way that optimistic investors claimed.

There is typically a feedback loop, as early adopters and investors make money, bringing in new money often inspired by early gains and the promises of potential innovations creating further growth.

These cycles often come at the expense of some of the most basic rules of investing, in that prices will not keep increasing forever, but as the feedback loops keep increasing, the greater the effect when everything stops.

 

Five Stages Of A Bubble

As well as many common causes, there is a theory, first posited by Hyman P. Minsky, that the basic pattern of an economic bubble consists of five stages, although exactly how long each stage is will vary based on many different factors.

Stage one is the displacement phase, which is not only when a new paradigm emerges but also when it catches on with early investors, displacing earlier investment strategies in the process.

The next stage is the boom phase when initial modest increases in stock price start to pick up as more people catch onto a new trending investment. This spreads outside to the financial press, and later to mainstream media as a whole.

This attracts not only more attention but also more investors and often leads to the third phase: euphoria. This is often where the “mania” aspect of many bubbles starts to take hold and optimistic valuations start to reach such ridiculous levels that they can only be true if every rule of economics happened to be wrong.

This is also where a lot of people lose their sense of perspective and risk management, as the potential gains are so monumental and constant that it can appear as if they are never-ending.

The fourth phase is the profit-taking phase, which is where the bubble starts to burst, the ludicrous prices have peaked and savvier investors are starting to sell off positions having been tipped off about potential warning signs.

The final phase is the panic run. Once it becomes clear that asset prices are about to fall, investors will liquidate for whatever price they can get, often at a significant loss.

What Should You Do When You Notice A Market Bubble?

It is difficult but not impossible to spot a market bubble in progress. Many people realised that cryptocurrency and especially the non-fungible token (NFT) boom of 2021 and 2022 was an unsustainable asset bubble which would inevitably burst.

However, predicting when the bubble will burst is very difficult, and generally, it is much more prudent to either avoid bubble assets if you can, or exit early before the bubble reaches its peak.

Whatever your strategy, plan carefully and remain disciplined. Resist the temptations of fear and greed and keep your long-term goals in mind.

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