The hottest topic on everyone’s lips in the stock markets right now and the most frequently asked question by participants in the stock markets is “Are the markets in bubble territory?”. The bursting of an economic bubble is the personification of every stock market participant’s worst nightmare, because of the shockingly furious velocity at which asset prices plummet unabated, especially at a time when such a phenomenon is least expected.
Well, this piece attempts to demystify economic bubbles and their occurrence. But, before we go any further, let us at least understand what an economic bubble is.
An economic bubble, also called an asset bubble can be defined as a situation where the price of a publicly traded asset, is pushed to such heights by the sheer amount of money that is traded in the asset, that it greatly exceeds the asset’s intrinsic value. When this happens, the inflated prices can only be sustained for so much time, before asset prices plummet and revert to average asset prices.
Now, no one can perfectly time a bubble burst. Trying to do that would be like squeezing tooth paste out of its tube, and trying to put the squeezed out tooth paste back into the tube. Simply put, timing a bubble burst is impossible.
But, every economic bubble follows a set pattern and has a well defined life cycle. This life cycle can be segmented into specific phases. Each of these phases are further characterised by certain common traits which are easy to discern. An economic bubble can be broken down into the following five phases:
Displacement: This phase marks the birth of an economic bubble. Just like a bubble bursts when there is a sudden major negative event which is known as a black swan event, a new bubble is given birth to when there is a sudden major positive event which creates profitable avenues for some sectors, because of which the existing environment of fear and pessimism gets displaced.
Credit Creation: Just like we humans need oxygen to live and thrive, economic bubbles feed on money and credit. When green shoots of recovery start to emerge, central banks (in India’s case, the RBI) start to lower hitherto high interest rates, which makes borrowing more attractive. Banks also lend more willingly, enthused by the backdrop of steady economic recovery. New banks are set up to further aid the process. This is why this phase of an economic bubble is known as the nurturing phase of an economic bubble.
Euphoria: This is when alarm bells actually start to ring. But this invariably happens at a time when the economy as a whole is in the pink of its health, and so, any negative news or warning signals are discounted, and therefore, these alarm bells sound more like a melodious chime, and are looked at as an invitation to party rather than as a caution not to. Everyone starts to buy into the superficial story of economic growth and health and a wave of renewed optimism lashes through the markets. Participants in the markets can’t envision a crash and therefore, keep pushing market valuations higher and higher and higher.
Critical Stage: This is when things start to get really ugly. Because valuations have been pushed sky high even though there is some amount of negative news, company insiders and value investors start to cash in on their positions and slowly start exiting the markets. The more ignorant and greedy participants continue to stay invested, sometimes even using leveraged capital to continue fuelling the markets. But there comes a tipping point, where the bad news is just too severe to ignore. At this point of time, exorbitant valuations cannot sustain themselves and asset prices begin to plummet at an almost hemorrhagic rate. Wealth created over a number of years goes up in smoke in a matter of weeks and months.
Reversion: Investors are so badly scarred as a result of losing so much of their money that they go away with their tails between their legs, petrified at the thought of entering the markets again. As a result of this, assets fall to dirt cheap prices, actually representing attractive bargains for investors.True value investors enter the markets at this point.
So that was a brief overview of the various stages of an economic bubble. As far as the Indian markets are concerned, it is my humble opinion that we are transitioning from the credit creation stage to the euphoric stage, as we are showing signs of both stages.
The government is focussing most of its attention on financial inclusion across the country which has boosted credit creation. The recent steps taken to revive the banking sector, most notably the PSU bank recapitalization drive, is another step in that direction.
But at the same time there are undoubtedly some warning bells we should ideally pay heed to. Crude oil prices keep hitting new highs every third day, GDP growth is muted, the rupee is relatively soft, the bull market in America could be on its last legs and the benefits of GST are yet to truly kick in. But in spite of all this, markets keep discounting the bad news and continue their upward journey. And while there are some sections of the markets which are still skeptical of the continued upward move, there can be no denying the fact that the first signs of euphoria are also undeniably starting to show.
All in all, I hope this piece helps you understand economic bubbles better, and helps you in exiting the markets at the the right time with all of your wealth intact, and just, as the title says, before the bubble bursts.
?)