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Back to Basics: Understanding the Cycles of a Market Bubble
by Optionetics.com
Wednesday, April 22, 2009By Jeff Neal
www.optionetics.com
A market bubble is best defined when a particular market trades in high volumes at prices that are considerably higher than the real or intrinsic value. Market bubbles usually are temporary market conditions created through excessive buying that leads to unfounded price increases.
The problem is that it is often difficult to observe what real values are in real-time markets and bubbles are often identified only in retrospect, when a sudden drop in prices appears. This big decline in price is commonly referred to as a bubble burst. In addition, the crash that usually follows a market bubble can destroy a large amount of wealth and cause continued economic difficulties.
Another important characteristic of market bubbles is the impact they have on spending habits. Market participants with overvalued assets tend to spend more because they feel richer, which is known as the wealth effect. We do not have to look any further than the housing market in the United States as an instance of this effect. When the bubble inevitably bursts, those who hold on to these overvalued assets usually experience a feeling of poorness and tend to cut their spending at the same time, adversely impacting economic growth.
Given the bubbles we have experienced in the past decade, from Internet stocks to commodities to the housing market, there are some clear stages that seem to appear in each. First is the stealth stage, where the big institutional money or smart money quietly makes a market entry. As a result, asset prices in this particular market slowly increases while at the same time the retail investors do not really take notice.
The next stage is awareness, where the price increases start to get more and more attention from the general public. Given this increased interest, prices climb even higher coupled with a little short selling. However, on any price retracement you typically see that the early investors will see this as an opportunity to add to their positions.
Then we come to the mania phase, where virtually everybody is getting on board, viewing it as an incredible opportunity. Now even more funds flow into the market; meanwhile, institutional investors are starting to get out of their positions.
Finally, we have the bust or blow-off stage, where there is an absence of new institutional capital, which leads to declining prices. However, many investors who entered the market relatively late still insist that there is a big upside still remaining. This tunnel vision leads to a temporary stall in prices until the towel is eventually thrown in and the bubble actually bursts.
Keep in mind both the boom and the bust phases of a market bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances.
Happy Trading.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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