Financial Bubbles & Crashes in the stock market is the period of unusual positive & negative returns due to rises or fall in the prices of the stocks which is caused by panic buying & selling, neither of which is based on the fundamentals of the companies and economy. Most famous Bubble & crashes were 2008 US subprime lending crisis, Dot-Com Bubble (1995-2001), Black Monday – Stock Market Crash of 1987.
Bubbles and Crashes is unprecedented rises or fall in the market prices of stock which are two standard deviation from the mean. Bubble is the economic cycle where there is a rapid expansion in the market followed by sudden contraction. A crash usually denoted as 30 % or more fall in the prices over several months. As compare to crash, bubbles usually develop slower than crash.
In Bubble, asset price surpasses the fundamental value and traders become sequentially aware that prevailing prices has been departed from the intrinsic value. However, the market timing is very difficult task; most of the traders do not know when to exit the bubble market. Due to lack of exit strategies among the investors & traders, allows the bubble to grow further. Because of the anticipation of further increase in the market prices, Investors & Traders stay in the market. Sometimes, even institutional investors who are considered more informed get caught in this phenomenon, where even they don’t know when to exit the overvalued market. There is a very famous instance where Hedge Fund Manager who used to manages world famous investor George Soros’s Quantum Fund during the Technology Bubble, was asked why he didn’t get out of the internet stocks earlier even though he knew that these stocks were overvalued, he replied that he thought rally in the market wasn’t going to end so quickly and he said “We thought it was end of eighth inning of rally and start of ninth rally”. Facing with mounting losses, he resigned as Quantum Fund Manager. In early 2000, the technology stock bubble crashed spectacularly as the NASDAQ Index fell from 5,000 to nearly 1,000 by 2002, pushing the U.S. economy into recession.
Although explaining Bubbles and Crashes is very complex issue, following are the causes which have led to bubble & crashes in the past:
1. Easy Credit: Reason behind 2008 financial crisis happens in US- Real estate buyer in anticipation of further rise in the prices of real estate buy the overvalued real estate properties and banks were giving easy credits on the basis of overvalued real estate properties.
2. Liquidity: Because of expanding monetary policies where central bank keeps the base rates low and inappropriate lending by banks causes situation of excessive liquidity in the economy, due to which money flows to the few good assets and pushes the assets artificially upwards making business valuation expensive.
3. SubPrime Lending: Bank offered loans to those people whose credit score are really low and have difficulty in making the repayment schedule. Subprime lenders buy the properties in the already overheated market, giving further push to assets prices.
4. Regret Aversion : When assets prices rises, most of the investors follows the market trends, they also start buying the overvalued assets in the anticipation of further rise in the prices because they don’t want to regret and don’t want to miss the current rally.
When asset prices becomes overheated to the extent where prices cannot be justified by their fundamental or intrinsic value, bubble get busted and the market undergoes a correction, usually at least a 10 percent decline. In more extreme cases, the devaluation may trigger a market crash, which is a much more significant and sustained drop in the total value of the market (usually 20 percent or more), causing massive losses, thereby pushing the economy in the recession or sometimes depression.
In order to avoid getting trapped in bubble stock market, investors should always do fundamental analysis of the company, industries in which company is operating, economy state of the country and should also check global scenario. Check whether current market price of the stock justify the fundamental values and sometimes it is not right to invest just because some famous investor is investing in the company’s stock. These days most of the developed countries central bank is keeping their base rate low in order to boost their economy by providing credit at very low rates. Because of easy in monetary policies, bonds prices of many corporate have shoot up, as market yield to discount value these bonds are surprisingly low, due to which bonds are acting like stocks and speculators are speculating that Fed Reserve of US, European Central bank (ECB) & Bank of Japan will keep base rate low for longer time and these speculators are investing in corporate bonds in order earn return on further rise in bond prices, creating bubble in bond market.