Before starting to invest in stock markets, I had heard bubble in some different context altogether. When I was a kid, roadside vendors used to sell those kits. You blow into them after dipping it into a solution kind of thingy and there were bubbles all around. Even today, as I purchase something for my niece, I still see some variant of that toy around. Later, when I grew up and went to a decent hotel for the first time, I found something rich people use- Bubble Bath. Something that created foam while you are bathing in bath tub. But what is stock market bubble then? Is it something similar? Principally yes.
A stock market bubble is an event characterized by rapid surge in the stock prices. This fast inflation in the stock prices is usually followed by a sharp correction or downfall which is also known as a “Market Crash” OR “Bubble Burst”. The prices tend to match the actual value of the stock in this case. A bubble may not be typically used in terms of stock markets alone. A bubble can be formed in assets like Gold, Mutual Funds, Real Estate etc.
Characteristics of a Bubble:
Surge without Fundamental Support:
A bubble is typically characterized by the rise in price much above the intrinsic value of the underlying asset. Fundamentals of the product remain the same while market pushes the price much higher due to some reason. I will share one example of such case of Reliance Industries. When the pandemic hit, Reliance was trading around Rs. 875. Within a few months, Ambani decided to sell stake in Jio with an aim to become debt free. Therefore we saw multiple rounds of investment from Facebook, Amazon etc. in Jio. There was no change in fundamentals whatsoever with this move, however stock surged to the levels of about Rs. 1600 in a matter of few sessions. It is not the sales, profits, business strategy, numbers driving the price of the stock, rather people’s perception of the Reliance industries that has caused this surge.
The entire markets however will one day accept the truth and match the actual value of the stock. These crashes are sharper and tend to erode a lot of investor wealth if not taken care of. Let’s discuss a few examples of these crashes:
A. Dot Com Bubble:
Back in 2002, it was assumed that all those companies that have a dot-com in the end of their names are avenues of limitless returns for their aggressive investors. However, most of these companies lacked a proper business model and were simply burning the investor’s cash to stay afloat. Then the inevitable happened and prices tumbled at a rapid pace.
B. Real Estate Bubble:
Stock markets lost 30% of their value during the burst of real estate bubble in 2008. US government, in an attempt to fulfill the American dream of its citizens of ownership of a home decided to provide mortgages to people left right and center. With unprecedented growth in consumer debt, lending institutions had to accept their fate and declare bankruptcy.
Reasons Behind a Stock Market Bubble:
A. Excessive Money:
In situations like the one world was in 2020, economic activity had come to a complete halt. People were sitting on their piles of cash, afraid to spend or invest anywhere due to uncertainty in the environment. To jump start the economy, governments around the world tries to boost the liquidity by slashing the interest rates, decreasing the lending rates etc. Idea is to force people to spend more which in turn would pump up the economy.
And when governments put more money in the hands of the people, they tend to go all out and buy assets like stocks. Stock broker Zerodha saw a lifetime high in account opening requests ever since lockdown started. This phenomena is not only native to India, even in US, stock broker “Robinhood” became so famous that these new entrants of stock market were being called “Robinhood Investors“.
Due to newer people entering the stock market, prices of stocks saw new all time highs every other day.
B. Herd Mentality:
When a stock price keeps on moving upwards, one may think that majority cannot be incorrect. Therefore, they also go with the flow and invest in the same stock without evaluating the fundamentals. Hence, driving the price further up.
FOMO or fear of missing out is a prime driver in pushing the price of the stocks upwards. With the rise of social media and news industry, there is abundance of information available to us. At times this information does more harm than benefit. We feel we’re missing out on an opportunity and hence pounce on the asset. One news channel recently abused this mindset and were caught red handed. (source) Another example of FOMO was what happened with Gamestop. The only reason for a gigantic 15x rally was euphoria and FOMO around the stock.
While it gets really difficult to predict a bubble in formation (we don’t know if we are in one right now), least one could do is do their fundamental study properly before investing in any asset. Even if the stock markets involve a considerable amount of guess work, it has to be backed by some numbers and logic. And as I always say, if numbers don’t add up, avoid that asset. When in doubt, stay out.
I was a kid when 2008 bubble burst. How much did you lose in these incidents and in the past?
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Until next time..