What is a market bubble?

A bubble is when an economy, market or asset has a large price spike, exceeding what is considered to be its fundamental value by a large margin. Bubbles are usually identified in hindsight, generally after there has been a crash of the price of the economy, market or asset in question.

The damage caused by the burst of the bubble depends on the economic sector or sectors involved – the bursting of the US housing bubble in 2008 caused a global financial crisis, because most banks and financial institutions in the US and Europe held billions of dollars worth of subprime mortgage-backed securities.

The five steps of a bubble

Economist Hyman P Minsky identified five stages in a credit cycle – displacement, boom, euphoria, profit taking and panic – and this general pattern is fairly consistent across bubbles in varying sectors.

Stage 1 – Displacement

Displacement occurs when investors become infatuated with something new – new technology in the dot-com bubble, tulips in tulip mania (a bubble in the 17^th century where the popularity of tulips shot up so quickly that tulips started selling for over ten times the annual income of skilled craftsmen. Within months of the bubble bursting, tulips were selling for 1/100^th of their peak prices), or historically low interest rates, as in the US in June 2003, which started the build-up to the housing bubble.

Stage 2 – Boom

Following a displacement, prices begin to rise slowly. They gain momentum as more participants enter the market, causing the asset to attract widespread media coverage, then panic buying, which forces prices to record highs.

Stage 3 – Euphoria

Prices skyrocket – in the 1989 real estate bubble in Japan, land in Tokyo sold for up to USD139,000 per square foot. At the height of the internet bubble in March 2000, the combined value of the technology stocks on the NASDAQ was greater than the GDP of most nations.

During the euphoric phase, new valuation measures are promoted to justify the jump in prices.

Stage 4 – Profit taking

By this time, skilled traders start selling their positions and taking profits – sensing that the bubble is going to burst. However, determining the moment of collapse can be very difficult and, if you miss it, you have likely missed your chance to take profits for good.

Stage 5 – Panic

At this point, prices fall as quickly as they originally rose. Traders faced with margin calls and the falling values of their assets start panic selling – getting out of their investments at any cost. Supply soon overwhelms demand, and prices plummet.

In the 1989 Japanese real estate bubble, real estate lost nearly 80% of its inflated value, while stock prices fell by 70%. Similarly, in October 2008, following the collapse of Lehman Brothers, and the almost-collapse of Fannie Mae, Freddie Mac and AIG, the S&P 500 plunged almost 17% in that month. That month, global equity markets lost USD9.3 trillion, or 22% for their combined market capitalisation.

Conclusion

Being familiar with the steps of a bubble, whether it’s in the stock, forex, commodities or bonds market, may help you identify the next one, and get out before your profits vanish.