Before The Bubble Bursts

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.


Theoretically, I agree with all the statements that assets will get inflated. For instance, if companies are deleveraging their balance sheet, price earnings tend to be higher. It is only when companies have deleveraged their balance sheet, the earnings recovery would happen, which is followed by CapEx cycle. Nifty50 companies have started to report improvements in profits.

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Very Well Written .

In my opinion this market has still got a lot of steam left. There is an enormous deleveraging play going on and I except corporate balance sheets to be the best ever from 2019 onward. This market is intact till 2021-2022 or maybe even longer and that is when i think the critical stage will fall. There will be a major credit boom 2019 onward after the NPA mess has been cleaned up. Capex linked sectors will benefit the most.

Nevertheless, one must keep in mind that this is not only a one way street, the markets have to correct and that is healthy . But the big question is when ? - no one can predict it.

In my opinion this market is also in a transition - the macro benefits / Major reforms which have played out will slowly start trickling into company profits. Corporate Banks, capital goods, Infrastructure (Especially Roads, Port) Engineering , Media are the ones that will lead Alpha.

PHARMA will be the biggest loser.

This is just my two cents. Happy Investing !

Good article.There is a steady turnaround in the indian economy after 5 years of slow growth and over capacity.Looks like existing capacities are filling up fast and companies are planning new Capex.The results are clocking good double digit growth even after discounting the base effect.This year,2018 may continue to add to the exuberence in the stock market driven by both results as well as liquidity.

I agree with the stagewise cycles, this is consistent with economic cycle as well. Whether we are in euphoria phase or if we are in credit creation phase is a matter perceived individually.

If specific to Indian economy, I doubt the credit cycle would ever venture into the extended territory for the next 5-10 years. The young and growing population of India has not yet leveraged lending to its full potential yet. There’s expectation of a 10+% increase in working population over next decade, Moreover, the purchasing power parity is on an increasing trend. The pentration of debt is low and rising. Thus we can expect to remain in credit creation phase for a few years to come. However, not all sectors such as the IT sector are as dependent on unrealised debt potential.

Also, the dynamics of globalization requires analysis of an impact of other countries’ cycles on ours as well. The large economies experienced a downturn in 2008 and recovery from 2011-12 onwards. A cycle typically lasts 7-8 years hence there’s a belief that the US economy could witness a downturn in 2019-20. If it turns out true, this could have a major impact on our economy, fuelling a correction overall in spite of there being further potential for growth.

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I would recommend @Donald @hitesh2710 to throw more light on these topics. What was it like during the boom phases of the 2000s and 2007s? Can we draw some parallels?

Why is it always the case that such topics come when the elections are nearing?

This is a very critical question how & when correction will come & signs of corrections. Very famous quote of Warren buffet, " if you listen people in restaurants, public places, & returns from stock markets becomes very easy than it’s time to quit & rest in peace :grinning::grinning::grinning:.
Current status

  1. GDP growth is not so condusive
  2. Inflation has become complex issue, inflation control is due to killing demand, no improvement in supply chain management. Inflation may hit back.
  3. Crude is spoiling party across world which will make money costly worldwide, global interest are already on upward trajactory.

Indian markets are no where is bubble zone RightNow however lot of pockets have reached in bubble zone. Consumer goods trading at 60-70 PE, Metals PE doubled at 12-15 band. Pharma is trading at 10-15 PE band however still looks expensive due to future outlook.

Any upcoming events in equity marksts which can suck 6-7 lakh crore liquidity will trigger a major meltdown, logically that should happen somewhere in Second half of this year. My wild guess is IPO if NSE LTD will create huge demand, will time exit near to that point. Quarterly results need to be analysed before.

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@saravananb1994 To my common sense, market direction and market dynamics attract the limelight just before a general election, because the general elections usually go a long way to deciding the direction in which the country will travel for the next five years. Therefore, there is always a heightened level of attention and anticipation regarding the markets just before an election.

Moreover, the major sentimental reason for the markets doing well right now, is the fact that Prime Minister Modiji and the BJP are at the helm. So, the results of the next general election will be vital to the markets continuing the rally.

A BJP loss in 2019 may be perceived as a major negative by the markets. The upcoming state elections in Karnataka, Rajasthan and Madhya Pradesh would be seen as a precursor and a preview to what can be expected in the 2019 general election. Expect a major correction if BJP loses out in these states, for the simple reason that market sentiment is likely to be shaken if that happens.

I would agree with market corrections. People anticipate market crashes (since the PE is above 27).

A nice article though not directly related to Indian markets but relevant to the topic.

I have some queries here, with different perspective. Here’s the last mega bull run which lasted more than 4yrs with short term correction of 20% twice (marked in red circle).

Also, if you note the early 2007, there’s a sudden spike, followed by crash. But we are not seeing such spike in the current market, instead a steady upward movement with small hiccups.


  • Are we talking such correction before continuing the bull run ? what if the market won’t crash as expected (Plan A, Plan B :slight_smile: ?)
  • The PE is said to be 27, but don’t we think we should wait until all the earnings are declared for Nifty 50 to arrive the actual PE. Since, the current PE is priced for the Q3 results and the earnings are catching up, might touches 23-24 range again.

  • Don’t you think exiting in the middle of bull run which corrects not more than 20% and resumes the run ?

  • Completely agree this ! this will be a mini black swan event, if it happens. Let’s see if we can get a nice little correction(10-15%).

  • I have no idea in new investments, all the stocks in my watchlist are at lifetime high valuation, but I definitely won’t exit the existing positions, unless the fundamentals changes, if I get an opportunity of 10-15% correction, I’ll add more.

I welcome opinions!

A relevant article

The last three conditions seem to be prevailing in the current scenario.

Very interesting piece of information you have outlined, but the essential aspect is that these euphoric markets bring n investors who had never invested in the stock market due to recency bias and fear of missing out opportunity. It is irrefutable fact that the human nature can not change easily inspite if early warning signs as we tend to always feel this time it’s different…

A market crash is not because of high valuations alone , but valuations moving on hope rather that real numbers. Market crashes are preceded by true slowdown of growth on the ground, in multiple sectors and markets moving contrary to that. In 2007 this was the case for at least 6 months before the burst. That is not the case right now. Corrections 10-20% are bound to happen though. This is what I feel. Also - I hold on to my stocks if the growth doesn’t slow down significantly in a 2-3 year window, irrespective of corrections/crashes.

Very rightly said. These are some of the reasons why it is all the more important to educate investors on these aspects. A few common hacks to being a better investor would include being aware of behavioural biases, such as the recency bias you have mentioned. Also there is a very common misconception among investors that liquidity will eternally trump valuation and market fundamentals. Increased liquidity in a fundamentally soft market can only be a stay of execution and not a permanent solution because valuations, actual corporate performance and market fundamentals will always trump liquidity in the long run.

Just wait for a couple of quarters of bad performance at the fag end of the current bull run or a sudden adverse regulatory change by SEBI regarding equity mutual funds, and see how SIP books, one of the major reasons for sustained liquidity, begin to fall, and it is actually the excess liquidity in stocks where valuations have run ahead of company and market fundamentals, which invariably trigger a deep market correction or a market crash.

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@thecroc This is exactly what I have tried to say in the quoted section. Thank you for putting it in layman’s terms.

BJP under Vajpayee ji won MP and Rajasthan elections in 2003 and still ended up losing in 2004.
Elections are even more difficult to predict than markets. :slight_smile:

First of all, how should we perceive markets? It’s nothing but the barometer of current underlying emotions. And not to forget, it’s the lead indicator of underlying emotions. Some people are really good at reading it and most aren’t.
Coming onto question of markets and cycles, I have been reading a bit about 17 years super-cycle. According to this theory, world economy has seen numerous 17 years cycles, starting since late 1700s. Some observers claim that cycle is linked to land prices in US and has been observed like clock work in last 200 years or so. Of course, it can extend or shorten a bit, but time frame remains same. Usually cycle’s end (or bottom) is coupled with a big event. In 2008, it was the great recession and in 1991, it was beginning of gulf war. Now the cycle can be divided into 2 distinct phases, first phase of normal recovery which makes up for first half. Second is the phase when both consumer and capex cycle start going up. That is the time when markets move at the sharpest pace. It seems that 2016-17 marks the start of beginning of second half. Let’s see how it pans out.

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@Mayank_Narula That is a very interesting theory you have there. 2 phase, 17 year cycles. Also, given that you say that 2016-17 marked the beginning of the second phase of the 17 year cycle for the Indian markets, are you saying that the current bull run will theoretically last for around another 8 and a half years? Just basing this question on the back of elementary math which says that 17/2 = 8.5 years.

If 2009 is considered that start of fresh cycle, then it can go till 2025-26 may be.
Amazing thing is, I first read this theory around may-june of last year in a article written around sometime in 2016. In that particular article, author predicted there will a start of up cycle in commodities such as crude and steel. It was a bold prediction in 2016 to talk about surge in oil prices when Goldman and likes were predicting 20 USD per barrel.

That’s what happening now. I was listening to Prakash industries post- earnings interview. Promoter Mr Ved Prakash Agrawal also mentioned about super cycle of steel for next 5 years or so. Exciting times we are seeing.

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Bull market has entered Final lap: Ambit Capital