How To Recognize A Stock Market Bubble Before It Bursts

taliTali Soroker is a Financial Analyst at I Know First.

How To Recognize A Stock Market Bubble Before It Bursts

Summary

  • What are market bubbles?
  • What causes bubbles to form?
  • Historical examples of various market bubbles
  • I Know First’s predictive capabilities

Stock Market Bubble

Introduction to Market Bubbles

Think of a market bubble like a soap bubble, the kind of bubble that kids blow up out on the sidewalks in the summer. As the kid blows, the bubble grows and grows with no indication that it will stop, until it pops. These bubbles are transparent, hard to see without the sunlight glinting off them. Market bubbles are significant growths in the market that are not based on anything substantial. Just like soap bubbles, they can pop with no clear warning and simply dissipate into the wind.

Bubbles are created when the price of a stock or of a good increase dramatically without any sound reason. Often the cause is as simple as people getting carried away with what they believe for whatever reason is a sound premise. People hear from their neighbors that something is going to be a huge success and can’t possibly fail, and then a combination of mob psychology, fraud, greed, and government incompetence causes the formation of a bubble that is bound to burst. Unfortunately, it is essentially impossible to prevent bubbles from occurring because they are so hard to see until they have already popped. What follows the burst is usually a recession or even depression in the market. While the majority of people suffer in the wake of a market burst, historically, there are also a few people that are able to see the bubble forming in time to benefit from the burst that follows.

One of the easiest ways to understand what market bubbles are and how they form is to examine historical examples.

The Tulip Bubble of 1637

The occurrence of bubbles is nothing new. In 1593, the tulip flower was first introduced to the Dutch. The bulbs were initially considered to be a novelty, and after their introduction to Holland, they contracted a non-fatal disease that transformed the colors of the already unique flowers. The demand for the flowers and their bulbs lead to extreme inflation of the price. Eventually, people were trading their land and life savings just to get a hold of these bulbs. In just one month, the costly flowers saw a twenty-fold increase in price. Eventually, some buyers decided to exit the market and to solidify their profits. Once some started to sell, a domino effect incurred and bulbs started to sell for lower and lower prices before the entire market crashed. Looking back, it’s pretty easy to see that a bubble formed in the tulip market just by glancing at the prices that the precious flowers were selling for. At the top of the bubble, a single tulip bulb could be traded for a family’s entire estate, yet people didn’t see what was happening at the time.

Stock Market Bubble

The Great Depression

The Great Depression is another good example of how a market bubble is formed and an even better example of the disastrous effects that follow the burst of a bubble. The typical cycle of euphoria and unrealistic speculations leading to financial crisis started with the Roaring 20s. After World War I ended, industrialization and prosperity ensued in the United States. People began to invest their money in stocks with the belief that the market only ever went up and that trading stocks were essentially risk-free. Amateur investors entered the market with little knowledge of finance or how the economy worked and traded stocks without understanding the fundamentals of the companies that they were trading. In an attempt to slow the rapidly increasing market, the Fed raised interest rates several times in 1929. A bear market followed and investors began to sell their stocks, and “panic selling” ensued. The crash of 1929 was so dramatic that in 3 days, more than $5 billion in market cap was lost. By the end of the crash, $16 billion in market cap was lost from NYSE stocks. Not only did millionaire investors lose their money, but banks that had invested depositor money also lost what they had invested. As a result, people who had not invested their money in the market at all lost their savings in the crash as well. The Great Depression started, and mass poverty became an epidemic with a third of the US population living below the poverty line.

The Housing Bubble in 2008

In the early 2000s, the Fed kept short-term interest rates low in an attempt to boost the economy following the bursting of the tech bubble. This, combined with a boom in the housing market, contributed to the eventual burst of a housing bubble that led to the worst recession in the US since the Great Depression as well as a worldwide financial crisis. As housing prices continually increased, homeowners viewed their houses as fail-safes. High-risk mortgages were introduced and it became common practice for people with bad credit and inadequate savings to get mortgages that would be difficult to pay off in the long-run. However, with the belief that housing prices would continue to go up, there seemed to be a little risk since homeowners could always sell their homes at a higher price than they had paid. The bubble burst when the “sound premise” that housing prices could never go down, was proven wrong. People across the country started to default on their mortgages, houses were foreclosed on, and the entire housing market collapsed. Banks and investment firms started to fail and soon the entire economy was failing. Only a handful of people saw the bubble before it burst, the majority of people involved were blinded to the situation by greed and their unwavering and unfounded belief that housing prices could only go up.

Stock Market Bubble

Predicting the Burst of a Market Bubble

I Know First’s machine-learning algorithm produces daily stock forecasts by tracking and predicting the flow of money between markets and investment channels. Each security has an imaginary point of equilibrium, called the “fair price,” and the market is constantly overshooting or undershooting that price. The algorithm analyzes the price history of securities in order to discover that point of equilibrium and forecast the likely direction of their respective trends. The analysis produced by the algorithmic system includes objective factors such as fundamental valuation and price momentum, rather than emotional factors that people are often influenced by when making trades. Market bubbles form for a combination of reasons, but perhaps the biggest influence is human emotion. This algorithmic system is completely empirical and doesn’t consider unfounded human assumptions or catchy phrases like, “the trend is your friend” in its decision making. It uses artificial intelligence and machine learning to detect patterns in the data that can reveal a bubble before it bursts so that investors can act on foreknowledge rather than blindly following the herd.

Stock Market Bubble

(I Know First’s forecast of the AAPL bubble in 2012)

 


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