The 5 Stages of a Financial Bubble

Popping the bubbles of high returns with behavioural finance 

By now, you may have heard of financial bubbles. The biggest recent examples of financial bubbles are the dot-com bubble in the late-1990s and the global financial crisis (“The Lehman Crisis”) in 2007-09, ignited by the US housing bubble. Both ended in massive crashes.

The current market behaviour (Summer 2022) looks like a crash, possibly (probably) one which may continue as we move into a likely recession. The relatively new and somewhat arbitrary round number of 20% being “a bear market” (and 10% being “a correction”) has been breached in many asset classes, but, as always, it has been hard to call when the bubble built up throughout the preceding bull market would burst. And it’s been quite a bull market, the longest in history for the S&P500! 

Hindsight is wonderful; you will likely come across many market commentators and strategists who will claim they “called the top” and build lucrative careers around that one call. But many other seasoned investors who “got off the train” too early for equally fundamentally sound reasons are either rubbing their hands with glee or unemployed.

What may be “different this time” is that it may not be “different this time”! “Different this time” (like “new paradigm”) is what experienced investors tend to laugh at when market noobs get overexcited by something they’re first experiencing, but which may have echoes from past market and economic activity. We prefer a more ancient idiom, “there is nothing new under the sun”. Or at least, according to Mark Twain, “History doesn’t repeat itself, but it does rhyme”!

In the current case, the “Fed Put” (the response by central bankers to large market disturbances by “printing money” or, more accurately, expanding the balance sheet) has only been around since the 1990s, before many of today’s investors and traders started in the market. Inflation, largely absent since that decade in much of the West, is a “new” phenomenon that lies outside their market experience. So with steep inflation dictating the response of central bankers the world over, this seems like a New Paradigm (!) when in fact, many examples exist of inflation and the recessions that accompanied them (and the market declines or stagnation that usually also took place.) 

That said, there are, of course, many ways that this cycle actually is different, such as having easy money for a decade after the Global Financial Crisis, the Covid-19 pandemic and the enormous fiscal and monetary response to it, and perhaps the sluggishness of the Fed to act earlier on signs of inflation. All come together with a stagflationary supply shock and a disruptive land war in Europe to produce a confusing combination of inflationary and recessionary forces against a backdrop of high debt levels (thanks to booming property prices) and hence financial vulnerability.

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So will we see a more aggressive market decline than we have already seen, especially considering how widely expected (hence possibly “priced in”) the impending recession is? And will it bounce straight up after the bottom is reached or stagnate for months or years? Or drop again like a rock after a sharp rally (known in market parlance as a “Dead Cat Bounce”)? Maybe. Maybe not. Sorry. We may not be smart enough or lucky enough to call the tops or bottoms of markets, from shares to bonds to crypto, gold, farmland or real estate, so we don’t try to. If you pick the absolute top or bottom of a price, you’re not doing it right, despite the bragging rights! But we know it’s better to buy things that have value for less money than for more money. 

The term “bubbles” comes about from the initial price surge of a type of asset or group of assets seen as inflating a giant, fragile bubble. Once the bubble pops, i.e. when investors realise that the assets are drastically overpriced and overvalued, the price comes tumbling down, creating waves of losses for investors who are still in. Obviously, no one wants the wave to catch them. Economists have identified 5 stages of a financial bubble that all investors should know.

Stage 1: Displacement

When investors get excited about something new or unconventional, they start looking more keenly into the topic. If this new topic has potential, investors will start pouring their money into it. Examples include new technology leading to the dot-com bubble or historically low mortgage rates leading to the housing crisis.

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Stage 2: Boom

This excitement increases demand for a particular financial instrument related to the source of excitement. The sudden increase in demand leads to a large rise in prices, which will attract news coverage and discussion, giving the financial instrument even more publicity. This leads to a growing cycle of overexcitement as the number of investors and capital involved increases exponentially.

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Stage 3: Euphoria

The price is rising, and caution is thrown to the wind. Even with extremely high prices, investors are willing to pay even more because investors expect it to continue rising. Hence, prices continue to climb and climb and climb. Yes, this is the classic situation in which your taxi driver is trading stock tips with you, and friends are quitting their jobs to become full-time “investors” in whatever asset happens to be currently booming. 

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Stage 4: Distress

Once the price is too high, earlier or more risk-averse investors start to pull out, taking their profits and leaving the market. As more investors seek to sell, the price hikes begin to slow, alerting other investors that a reversal may be coming because, deep down, many investors will have been asking: “Has the price already run too far, too fast? Can we justify valuations expanding even further? How high can this possibly go?” 

It’s pretty much impossible to pinpoint the exact point where distress will hit the market. After all, by this point, most investors aren’t trading rationally anymore (at least based on classical investing fundamentals). 

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Stage 5: Panic

It doesn’t take much to burst a bubble. However, once enough investors realise that the disparity between price and “value” is too much, or if they expect the price to start tumbling for any other reason, it will. When people start pulling out, others will panic and start pulling out. Prices reverse and fall just as fast, if not faster than they rose. Investors scramble to sell the asset to prevent further losses, leading to an even quicker price fall as supply overwhelms demand. This process is especially the case when potential buyers are happy to withdraw their bids, sit back and look to come in at lower (and lower) prices.

Bubbles are obvious in hindsight, and it’s relatively easy to pinpoint the 5 stages after they have occurred. However, while it is happening, it’s hard to tell, and that’s why they still occur. So, it is imperative to be on the lookout for such bubbles. By paying attention to how you trade and your investing psychology, you can prevent yourself from entering positions simply for the “hype” and getting sucked into a financial bubble that you didn’t even know existed.

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