Will the stock bubble burst soon?

By Larissa Fernand |  17-12-20 | 
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About the Author
Larissa Fernand is Senior Editor at Morningstar.in. Follow her on Twitter @larissafernand

Just as I began writing this, I came across an article by Martin Wolf in The Financial Times. He, for one, is not convinced that stock markets are in a bubble. Provided corporate earnings are strong and interest rates ultra-low, stock prices look reasonable.

Cliff Asness once remarked that the term bubble “should indicate a price that no reasonable future outcome can justify”.

So I thought it best to refer to the experts. In Manias, Panics and Crashes, Charles Kindleberger outlines the five phases of a bubble. 

Phase I: Displacement

All bubbles start with some basis in reality. An event or innovation or disruption that sharply changes expectations and generates excitement. Bubbles start with a displacement, a shock to the system, a new opportunity in at least one sector of the economy: end of a war, major political change, deregulation, technological innovation, financial innovation or shift in monetary policy.

An example of disruptive technology is the widespread adoption of computers, the internet and email in the U.S. in the 1990s. This set the stage for the dot-com bubble. A fundamental change in an economy would be the opening up of Russia in the 1990s that led to the 1998 bubble. 

Phase II: Boom

The narrative gains traction. Optimism grows. The narrative gets reinforced. The positive feedback loop bids up asset prices (be it stocks, commodities or real estate).

Loose credit and easy lending fuels the boom. Borrowers become more willing to take on debt and lenders are increasingly willing to make riskier loans as economic prospects improve.

The Tulip Mania in 1636 in Holland was fuelled by vendor-financing from bulb sellers. In the 1920s in the U.S., people believed that technology like refrigerators, cars, planes, and the radio would change the world. To finance all the new consumer goods, installment lending was widely adopted, allowing people to buy more than they would have previously. In the 1990s, it was the Internet. Companies resorted to vendor financing with cheap money that financial markets were throwing at Internet companies. In the housing boom in the 2000s, rising house prices and looser credit allowed more and more people access to credit. 

Phase III: Euphoria

Individuals extrapolate recent price increases into the future, expecting prices to continue to increase at unsustainable rates.

As the social media attention grows and people see their neighbours and aunts make money, the fear of missing out (FOMO) throws caution to the wind. As Kindleberger says, “there is nothing as disturbing to one’s well-being and judgment as to see a friend get rich.” Some realize that there is a bubble but continue to participate believing they can sell in time. Debt compounds as people borrow or trade on margin to further speculate.

(Robert Shiller echoes the identical sentiment in Irrational Exuberance: I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.) 

The general perception is that it is easy to make a quick buck. Day trading is perceived to be more lucrative than the regular day job. Euphoria makes people think the good times will last forever, or at least for a long time and they will be well aware as to when to exit.  

Phase IV: Crisis 

Distress sets in. The selling begins. As the selling gains momentum, the speculators too latch on.

It could be an event that causes a decline in confidence or a pause in the explosive momentum. A bankruptcy, a change in government policy, a piece of news (real or rumoured), or a flow of funds from the country. 

Phase V: Revulsion 

Euphoric buying has given way to panic selling. The bubble has burst. Greed has given way to fear. The contagion of bad news has changed the narrative. Things will never get better. The sky has fallen.

Everyone tries to sell at the same time. Prices plummet to irrationally low levels. Leveraged companies begin to go bankrupt. The sell-off spreads to other sectors. Bankruptcies mount. Credit dries up. 

Is it time for the bubble to burst?

While each bubble may have its own distinguishing characteristics, the key ingredients are a confluence of numerous factors: Innovation or the perception of it, speculative leverage, and the emotion and psychology of investors – collective delusion.

The crash will happen. It always does. History is a prescient guide because human nature does not change. The question is when?

Howard Marks has often commented that cycles occur with regularity throughout history even if one is unable to pinpoint exactly when they will come.

The truth is that one can never know how long each phase will last. As George Soros said in an interview in August this year, “the stock market's rally is trapped in a Federal Reserve-formed liquidity bubble”. As there are no laws of nature or physics at work, there’s no telling how long this liquidity-fuelled rally will last.

I resort to quoting Shiller again: Those who predict avalanches look at snowfall patterns and temperature patterns over long periods of time before an actual avalanche event, even though they know that there may be no sudden change in these patterns at the time of an avalanche. It may never be possible to say why an actual avalanche occurred at the precise moment that it did. It is the same with the stock market and other speculative markets. 

Have I answered the query? No. But it is no stretch of imagination to see that we are right now in Phase III. And before I proceed to venture any more guesses, I am reminded of John Bogle’s “Nobody knows Nothing”.

Investment Involves Risk of Loss.

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Jan 13 2021 03:36 PM
 Hi Ms Larissa, good article. I suggest lets bubbles be back, it brings air !
We want the Fizz back in the market. Lets snatch the Fizz from the Virus.
Meanwhile I am only an observer
nagarajan balasubramanian
Dec 30 2020 12:09 AM
 An interesting article. well presented. Good to read and guides to ACT before the storm, which no one knows when it will come
Sunil Radhakrishnan
Dec 29 2020 02:45 PM
 A bubble is known only after it pops!. Agonising over the prospective pop is a meaningless exercise. We really don't know when inflation will rear it's pretty head in the Western world or when the fed will withdraw the punch bowl. So, it takes us back to vintage advice. Stick to our original asset allocation and limit our downside and save our backside when the music stops.
ninan joseph
Dec 19 2020 09:39 PM
 Not sure of one thing. Experts always say to buy when there is panic and sell when there is greed and things like this.

What I want to understand is why were the FII who were mostly funds and investors money were selling when the market was crashing. I can understand shorting but what we witnessed was not shorting, it was selling and taking money out of India. Arent these experts paid to do exactly the opposite to buy at these levels. HDFC was available at 750, same with Reliance which was around 1200 or so.
If you ask me why this market is rising so sharply is because those FII who scooted are coming back to buy because they will be questioned by the investors as to the AUM or Corpus. As this is mainly retail investors no one will ask or bother to ask about at what rate they sold and what rate they are buying it back.

It is because these FII who were caught with the pants down when they scooted are not trying to pull back their pants by buying and hence the nifty is rising so fast.

Hope investors will question these AMC and fund house as to what they actually did when the market had crashed.

Want to know what warren buffet who give pearls of wisdom as to whey he did. Of course he is quite old now but what about others.

Think of AMC buying HDFC at 750 and now it has doubled at 1400. All top notch company were at throw away price. Now you get to see the media trying to ask the same experts what their views and they start drooling about what to do and not to do. Media ask what did these guys do when the market crashed. I am sure the answer will be i held both my hands between my legs and kept watching the market.
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