Money Is Forever Blowing Bubbles

The share market is cyclic. It goes through periods of boom and bust, bubbles and crashes. Empirical evidence suggests the cycles are becoming faster.

A price ‘bubble’ sees the prices of assets traded within a market escalate. Often prices on a chart will take increasingly sharper ‘angles of attack’ as the trend becomes steeper and steeper. One-eyed, overly optimistic investors usually overlook the underlying value of assets and their fundamental considerations. “But this time it’s different” is often the catch cry of those (greedy) investors who continue to buy in the face of mounting fundamental challenges. When a bubble bursts, prices fall rapidly – often to just a fraction of those seen at the highs.

A bubble precedes virtually all market crashes. Without fail they are driven by fl awed market sentiment.

In the last 80 years we have experienced four separate and devastating market crashes, the crash of 1929, which led to the Great Depression, the crash of ’87, the ‘Asian meltdown’, and most recently the ‘Dot-Com’ crash. Each were the result of a ‘bullet proof’ attitude that the prosperity would never end, that it was a ‘new economy’, and each has seen share prices elevated to levels which couldn’t be justified or sustained.

Beware the herd mentality that stocks will continue to go up simply because they have been going up. Stock prices should reflect, amongst other things, a mix of future earnings potential, assets, shareholder returns, and returns relative to other asset classes. They should not simply be the result of “If I don’t buy now, I’ll miss out on all the profits”.

I have broken down the development cycle of a bubble into four basic phases:

Phase 1 is where the professional and contrarian traders identify a new trend, they see the potential profits to be made and invest heavily.
Phase 2 is the period when the second tier of professionals and day traders start to get in, still relatively early days for the boom, but it has momentum.
Phase 3 is when the institutional buyers finally get in on the act. Conservative by nature, they have been aware of the emerging trend for some time but their risk aversion has kept them out. Finally, they can ignore the trend (and substantial profits) no longer. They invest their considerable weight of funds into the trend. Of course this prolongs the trend, and increases the gains for the first two waves of buyers.
Phase 4 movements become major news. Everyone seems to be a guru and an overnight share market tycoon. Investors are only aware that the market can go in one direction – up! The ‘mum and dad’ investors decide to invest heavily to capture some of the ‘easy’ money on offer.

Of course by the time phase four rolls around, the initial investors are beginning to sell to lock in profits. Being a smaller and more sophisticated group of traders, they will not simply dump stock onto the market causing the prices to fall. Rather, they will carefully sell down their positions over a period of weeks and months.

Eventually, the realisation that prices have now attained dizzying heights is beginning to set in. Market commentators begin to talk about the overvalued nature of the market.

The ‘true believers’ in the ‘this time it’s different’ mantra often counter these criticisms. Historical precedents and common sense are ignored. This is the point where reality and the stock market meet. This is the point where bubbles burst.

Right now, however, there is an argument that even though the market is high it’s not actually overvalued. For some stocks this is very true, but too many others are beginning to creep into the expensive realm.

Moving forward there are signs that the economy is slowing, inflation is rising, and future earnings growth may not match recent levels. These are reasons for share prices to pull back, and if they don’t, then this could be confirmation that we may very well be in a bubble.

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