Euphoria

Date: 2015-10-07; view: 536.

Boom

Displacement

Bubble Characteristics

A basic characteristic of a bubble is the suspension of disbelief by most participants during the "bubble phase." There is a failure to recognize that regular market participants and other forms of traders are engaged in a speculative exercise that is not supported by previous valuation techniques. Also, bubbles are usually identified only in retrospect, after the bubble has burst. Economist Hyman Minsky identified five stages in a typical credit cycle – displacement, boom, euphoria, profit taking and panic. Although there are various interpretations of the cycle, the general pattern of bubble activity remains fairly consistent.

A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low. A classic example of displacement is the decline in the federal funds rate from 6.5% in May, 2000, to 1% in June, 2003. Over this three-year period, the interest rate on 30-year fixed-rate mortgages fell by 2.5 percentage points to a historic lows of 5.21%, sowing the seeds for the housing bubble.

Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be a once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of participants into the fold.

During this phase, caution is thrown to the wind, as asset prices skyrocket. The "greater fool" theory plays out everywhere. Valuations reach extreme levels during this phase. For example, at the peak of the Japanese real estate bubble in 1989, land in Tokyo sold for as much as $139,000 per square foot, or more than 350-times the value of Manhattan property. After the bubble burst, real estate lost approximately 80% of its inflated value, while stock prices declined by 70%. Similarly, at the height of the internet bubble in March, 2000, the combined value of all technology stocks on the Nasdaq was higher than the GDP of most nations.