Throughout history, attempts to mitigate the downfall of financial crises have been exhausted by politicians and elected officials with little avail. As manifested by the recent financial crisis of the housing bubble in 2008, the market forces that drive our economy are difficult to control, and investors cannot rely on the government for control. Governments generally have two options in response to a crisis increase spending and lower interest rates. However, the most efficient defense the government can assert is through monetary policy. Implementing policies that create a favorable business environment can undoubtedly reduce the crises, but the forces that rule the market are much stronger than the monetary policy can control. This lack of adequate government protection raises the question: If an investor cannot rely upon the government for price stability, what choices are available for the novice investor? There are generally two options: A layperson may altogether avoid investing and miss out on all capital appreciation of the market, or become knowledgeable about asset bubbles to prevent partaking in their development.
What is a bubble?
Defining an asset bubble is difficult due to widespread disagreement on a bubble's precise characteristics. Although economists and industry professionals disagree on the metrics that characterize an asset bubble, the generally agreed-upon meaning defines an asset bubble as a circumstance when asset prices far exceed the intrinsic value associated with the underlying security. The stretching of prices far from their intrinsic base empowers speculators to build their "castles in the sky."
Elements of a bubble
The extensive research on financial crises over the ages has led industry professionals to develop substantial theories of influential factors contributing to speculation-driven assets. Although various publications highlight a mixture of different characteristics, the author of this article believes the most significant factors were highlighted in Bubbles and Crashes: The Boom and Bust of Technological Innovation . Throughout the work, a pronounced emphasis is given to uncertainty, pureplay, and novice investors. However, the author of this article believes the additional factor of credit availability should also be considered when addressing the prominent elements of financial bubbles. The following includes a description of the required factors:
Uncertainty
By far, the most significant factor in any bubble is a story of riches awaiting discovery. Investors must believe that riches are within their grasp, and failure to act now will leave them with the distasteful feeling of disappointment. In 1825, speculation of riches and abundance in South America led the seeds of uncertainty to flourish. People wanted to risk their saving businesses excavating South America. Stories of riches and gold prompted the animal spirits within speculators to allocate funds towards bonds and mining companies. As stated best by Devil Take The Hindmost , some companies, "prospectus claimed that gold was so abundant in its concessionary area that it need only to be washed from the mud." Stories of such magnitude created tremendous demand for immediate action. Deceitful chiselers made sure to gain from the credulity of speculators, which led to the funding of "Poyais," a fictitious country created by Gregor MacGregor.
Credit Availability
The establishment of "castles in the sky" cannot be "solidified" without ample funding. Over time the availability of credit has fostered investors to speculate with other people's money. Leverage leads many "investors" to their ruin when a particular trade or "investment" takes an unintended turn for the worst.
Typically, when monetary policy encourages a prominent business environment by lowering interest rates and fostering spending, banks are encouraged to give out loans to achieve higher profits, even when debtors are less than creditworthy. These lending practices were the particular case that led to the 2000's housing bubble. The low-interest environment, mixed with greed, and lack of regulation of OTC derivatives, fabricated the perfect storm to create an asset bubble.
Pureplay
Pureplay is the ability for entrepreneurs to take advantage of a technological revelation and create a business amplifying the exposure to that particular technology. A pureplay ability is a prominent factor that should be considered when assessing a possible bubble's strength. Although not as strong as the elements mentioned above, significant consideration may be wise. When the public believes a technological revolution is underway, the market in anticipation may overestimate the impact of an event's potential. The vision of immense profits awaiting discovery can cause smaller firms to develop risky strategies on the sole basis of success for a particular technological evolution. This ability to bet on a pureplay leads to the overvaluation of companies that may be terribly positioned to succeed in any business environment, even if the technology becomes realized and commercially viable. A particular example stems from the dot-com bubble where companies could sell at valuations significantly higher should their name give the slightest hint of the internet affiliations. Although many enjoyed an unrealistic appraisal at the time, common sense tends to level out values to their intrinsic valuations in the long run.
There can be no thought of finishing for ‘aiming for the stars.’ Both figuratively and literally, it is a task to occupy the generations. And no matter how much progress one makes, there is always the thrill of just beginning.
Rookie investors
In the game of speculation, the rearrangement of wealth is the name of the game. Assets exchange hands, and the short-term gains are a result of short term spikes in demand for the underlying assets. The presence of rookie investors facilitates speculation growth as many are unknowledgeable of investment practices (e.g., the risk associated with the underlying asset or the valuation of a particular catalyst). Therefore, rookie investors tend to believe in the story regardless of how outrageous the valuations may seem. As a result, these tend to be the people who are injured the most from financial crises and the ones that aid the propping up of market values.
Stages of an Asset Bubble
To this day, Hyman P. Minsky's work on credit cycles provides the best framework from which asset bubbles are derived. In his publication, Stabilizing an Unstable Economy,he cultivates the credit cycle's influence in the neoclassical theory of economics as well as its effects on asset prices and governmental intervention. The link between overly inflated asset prices and the credit cycle is extensive. His research shows that most bubbles follow the path of displacement, boom, euphoria, profit-taking, and panic. As credit facilitates spending beyond the means of individuals, company profits rise and drive economic growth. However, what happens when creditors demand reimbursement? This eminent question leads to the rise and fall of asset prices and gives a glimpse into the stages of bubbles.
Displacement
In the beginning, the forces of the market are relatively dormant. The prices remain in a normative state of fluctuation as determined by the forces of supply and demand. However, a change in asset prices is underway. An external shift in the business climate generates valuations pleasant for anyone who's clairvoyant enough to foreshadow future changes. This stage is primarily a smart money territory. The few that recognize the state are bound to reap significant profits. They recognized the catalyst that will drive up the underlying security and begin their accumulation phase. This recognition does not entail the timing of the markets, but instead resembles a thesis of future valuations awaiting realization. When the displacement occurs, the market is initially very cautious; however, the slightest inclination in price appreciation is eminent. This initial stage is characterized by a revolutionary concept or idea that can potentially disrupt the market. Examples include the development of the internet, changes in monetary policy, geopolitical matters, etc.
Boom Stage
In the boom stage, prices of underlying securities increase rapidly, gaining momentum as more investors become aware of the catalyst in question. The price rises due to the regular forces of supply and demand, and speculators gain interest. The large gaps and percent changes of the underlying security become an opportunity as the underlying security triggers scanners. Traders overcome with the fear of missing out begin buying. Staring at chart patterns and other signals, they enter the market. The introduction of traders is crucial as many speculators, to seize large profits, begin to introduce credit through margin accounts. Therefore, the prices elevate to levels beyond what is considered normal for the mean.
Late boom stage
Usually, during the late stages of booms, a new group of speculators enters the market: the bears. The bears are gamblers that are more realistic in valuations and understand that the price of the assets is much too high. Pessimistic about the underlying stock and outraged by the increase in price, the bears seek an opportunity to gain from the stock's perceived downfall. Therefore, they set in their bets and borrow other people's shares through margin accounts. When their bets pay-off, they may profit immensely since fear is a very dominant force and causes prices to drop quickly in a state of panic. However, when the bears are wrong, in their attempt to time the downfall of the security, they may cause a tremendous uplift in demand. As prices continue to elevate, fear sets in amongst the bears since they need to buy at higher prices. The more the asset prices increase, the higher their losses. As fear turns to panic, they are forced to buy back the borrowed shares at higher prices, increasing the demand and elevating prices even further.
Euphoria
In the euphoria stage, all sound principles of valuation have left the table. The stock is an embodiment of the public's enthusiasm, and momentum is kept healthy by the people experiencing the fear of missing out (FOMO). The security has grown enough to gain widespan media coverage. The price appears to be going to the moon. Metrics of EBITDA and P/E are disposed of in their entirety. Everyone knows that the stock is highly-priced, but as long as they can dump it off to a greater fool, all is well. Gains are profound, and greed is amply seen in the eyes of bullish speculators. After all, they earned that money because of their "prudent" investment decisions.
Profit-taking
At this stage, money is pulled out from initial investments. The smart money, the players ahead in the game, recognizes that the gains cannot continue for much longer. Taking their expectations of the future into account, the smart money attempts not to time the perfect exit, but instead, to exit with gains sufficient for their initial expectations. In the price chart, the pullback is seen as an opportunity, an error in the fabric of time. As bulls fill in the gap with expectations of a continuous trend, the security's price makes a small comeback. This is usually denoted as a small pivot point in the price chart.
The Panic Button
Torn between greed and fear, the once optimistic market begins to doubt any further capital appreciation. As uncertainty fills the air, speculators rush to their broker and demand to sell. At this stage, the price plummets. Once again, the forces of supply and demand go to work, and the lack of demand causes an oversupply of the asset to bring the stock to attractive valuations, hence the saying of "buy when there is blood on the streets."
Conclusion
These are the general steps that typically lead to a financial crisis. However, predicting human psychology can be a challenging process, and thus by no means are asset bubbles bound by the aforementioned stages. In some cases, stages occur at earlier times, while in other cases, steps are skipped altogether. Nonetheless, the stages seem to set the scene from which a financial crisis typically occurs.
In conclusion, the rise and bursting of bubbles can lead to terrible consequences; however, becoming knowledgeable about the financial bubbles can further polarize an investor from a speculator and avoid falling victim to a financial crisis. In general, rookie investors mixed with uncertainty, easy credit availability, and pureplay investments are essential ingredients that may lead to an economic crisis. The stages provided above outline the steps that, mixed with the proper elements, may facilitate an economic downturn. In the future, accounting for these factors may be wise and lead to long term profitability.