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Understanding the Life of an Economic Bubble

Part of the Managing Your Investment Portfolio For Dummies Cheat Sheet (UK Edition)

Economists (or perhaps ‘bubblanalysts’) such as Hyman Minsky and Charles Kindleberger have identified five stages of an economic bubble. Take a look and see how you can identify and utilise these stages in your own investment portfolio:

  1. Displacement. This term simply means that some external shock, surprise or new piece of technology arrives that creates a whole bundle of new profitable opportunities. The dot.com bubble of the 1990s was a displacement as the Internet opened people’s eyes to the possibility of huge, global transformations in which entire industries may die and new business champions arise. From 2001 to 2008 the displacement involved a massive housing boom and the emergence of cheap, easy-to-access credit from large international banks.

  2. Credit creation. The initial phase of displacement creates an enormous boom and large amounts of capital flood into the sector. As those profit-making opportunities become more common, banks and credit institutions sense that they can make money and they offer loan and credit facilities to all and sundry: from hedge funds through syndicated loan facilities to huge private-equity houses that scramble to buy the best companies. Eventually demand for a particular asset outstrips supply, at which point all the money chasing a diminishing number of opportunities creates a massive increase in prices.

  3. Euphoria. The technical term for euphoria is momentum. Eventually all this enthusiasm for a company, sector or theme gets out of hand and the prices of shares keep trending upwards, hitting new highs. Debts start to pile up among those feverishly optimistic investors, helped by the promise of ever-increasing underlying asset prices.

  4. Financial distress. What follows is inevitable. Insiders cash in, sell shares and take profits. Banks start to worry about the risks and the share price of great growth stocks wobbles. Companies loaded to the gunnels with debt now find themselves in financial distress and the credit tap is firmly switched off. Frauds also become obvious as the tide turns against the sector: fictitious businesses suddenly find their cash flows dwindling to next to nothing. Mayhem breaks out and prices start to collapse.

  5. Revulsion. After the event, everyone admits that of course they knew secretly the situation was a sham all along. Credit is stopped, and sellers are forced to sell their rapidly devaluing assets into a market that’s choked with too much supply and barely any demand. Prices collapse and eventually everyone says that they’ll never go near these kinds of assets again. A stage of revulsion is reached and the share price of what’s now an ‘ex’ growth stock collapses. Eventually everyone moves on to the next big thing and prices flat line for many months if not years. Savvy investors say that everyone else has capitulated and then . . . quietly start buying again!

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