From the Dutch tulip mania in the 1630s to the South Sea bubble of 1719 and the internet bubble in 2000, how do you identify bubbles, why do they happen and do they always burst?
A bubble is an unsustainable rise in price. It’s when investors illogically value an asset far above its intrinsic value.
Bubbles can happen when there is an artificial flow of money which needs continuous flow to survive, whether this is through irrational exuberance of investors, monetary stimulus or easy monetary policies. I’ve written about easy money before, where artificial inflows fuel investment that is not sustainable once the money tap is turned off. Read more here about ‘Easy money '.
Obviously, the problem with bubbles is that the longer they go on, the bigger the fallout.
A bubble is different to a stockmarket crash or stockmarket correction, so it’s important to differentiate them.
A stockmarket correction is a normal phenomenon of any bull or rising market. History teaches us that these corrections are almost always a buying opportunity. It’s to be expected that corrections take place when the market has been powering ahead so strongly.
A stockmarket crash is usually more protracted. It can last a month like the October 1987 crash or about two years like the decline in 1906-1907. Again history tells us that a stockmarket crash tends to be a fall of more than 20%.
The crash of 1987, or Black Monday as it’s called, happened on Monday 19 October 1987. It started in the United States with the Dow Jones Industrial Average (DJIA) falling 22.6%; the biggest one-day decline in history. Similar falls then took place around the world. By the end of October, the Australian sharemarket had fallen 41.8%.
The Asian Crisis began in July 1997. The economic crisis was caused by various factors including Thailand’s ‘hot money’ bubble, Indonesia and Korea’s excessive exposure to foreign exchange risk and a series of currency devaluations. The Asian financial crisis resulted in the US having its third largest decline in history by point drop.
The dot-com bubble in 1999 saw irrational exuberance of investors resulting in phenomenal returns for internet stocks. Stocks like Amazon were up 400%. The internet bubble peaked on 10 March 2000 at 5132 points on the NASDAQ. In six days, the NASDAQ lost 9%. Two and a half years later, the NASDAQ had lost almost 80% of its value.
The key if you want to profit from bubbles is to run with the bulls and then step aside as the rest of the bulls run off the cliff!
Profiting is all about timing. Usually the last stage of the bubble is the part which sees the strongest price rises. This can be the most profitable time but unfortunately it is also the riskiest.
Ideally, I’d be looking for a strategy where if I was wrong I might lose a small amount but if I was right I’d stand to gain a huge amount. If you’re a more advanced trader, my product of choice would be long dated, ‘out of the money’ put options.
After a bubble has burst, it’s important not to jump in too quickly as downturns can last a long time. For example, after the internet bubble burst the NASDAQ declined for more than two years!
I would wait for an uptrend to form before jumping in to get a bargain.
Happy trading!
Julia Lee Equities Analyst Bell Direct