Economic Bubbles - dummies

By David Stevenson

Every UK investor needs to understand a simple economic cycle: how economic bubbles periods of madly trading assets whose market value far outpaces the assets’ actual worth — emerge.

Markets sometimes behave like frightened or excited animals; hence the widespread use of terms such as ‘bull’ and ‘bear’ to describe investors’ attitudes towards buying and selling shares and bonds. This observation of the investment community behaving like a herd and so creating economic cycles is more than just an artful use of words. The insights built into it power technical analysis and its copious use of charts.

Bubbling up from trends

Key to the origin of an economic bubble is a trend, which when established (whether heading upwards or downwards) is difficult to buck as an investor.

When investors get it into their heads that, say, markets are about to boom, and that companies are going to experience a rapid rise in profits, woe betide the solitary soul who stands in the middle of the herd shouting ‘it’s all a sham and is going to end in disaster!’. Not that the contrarians stop doing precisely that.

The bottom line is that perfectly harmless trends can quickly turn into something much uglier and more dangerous: bubbles with disastrous consequences. You may well remember the great growth sector of the 1990s — the technology dot.coms — and how the whole affair ended badly in an enormous bubble and then devastating bust.

Analysing the life of a bubble

Economists (or perhaps ‘bubblanalysts’) such as Hyman Minsky and Charles Kindleberger have identified five stages of an economic bubble:

  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 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 (using gearing/leverage on their margin accounts) 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. 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. 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!

No hard and fast way exists of definitively spotting a bubble in the making. Some analysts suggest that whatever measure you use — whether fundamentals-based measures such as the PE (price–earnings) ratio or moving averages — look for an average value, work out a single standard deviation measure based on this ‘average’ and then start taking risk off the table as the price heads over that one standard deviation level.

Many clever investors stay well away from a sudden increase in asset values. One general response that you can emulate is to take profits slowly as the market eases into a bubble while tightening up your downside stop-losses. By placing an order to sell your shares when the price dips to a certain level, you can minimise your losses in the event the bubble bursts.

Bubbles, however, are followed by busts and these busts can be fantastic hunting grounds if you’re a contrarian investor who wants to buy a quality asset at a much reduced price. But most such contrarians only enter a market after everyone else has capitulated: that is, prices are low, volume is low and institutional investors have abandoned the asset.