A Journey Through Investor Psychology and Market Dynamics to Understand the Allure and Risks of Asset Bubbles.
Asset bubbles are formed when asset prices run far ahead of their fundamentals for a long time. Excessive investor interest in a particular company, sector, or theme and the consequent investor rush towards related assets cause the respective asset prices to run far ahead of their fundamentals.
The excessive interest usually follows a technological or financial innovation that promises significant productivity gains. These innovations surely bring benefits and gains to society and the economy. However, there is less clarity about the extent and range of benefits.
Because they are novel, these ideas have no historical precedents to understand them accurately. Therefore, most said benefits are products of imagination, for the idea to appear emotionally appealing to investors.
Most companies trying to profit from the innovation fail, and much of the money invested in them will be wasted, as the history of previous bubbles has shown.
Even investors who know about previous bubbles and their ramifications actively contribute to the formation of the next bubble. Infatuated by the innovation’s anticipated benefits, these investors are convinced this time it is different. The future is so bright that no price seems too high for them.
Stocks are usually valued in multiples of their profit. If there is no profit to value these stocks, investors value them based on revenue multiples. However, most of these new-business stocks haven’t even started generating revenue. If there is no revenue, the stock is valued based on customer additions; if no customers, the stock is valued based on website visits.
Once formed, the shelf life of an asset bubble depends on the absence of adverse economic shocks or disruptive technologies. Its growth depends on attracting new investors and capital, which might require new gimmicks to inflame the investor euphoria surrounding the innovation.
Initially, investor euphoria and rapid rise in asset prices are confined to companies or assets directly involved in the innovation. Slowly, the euphoria permeates the broader market, driving prices of other assets or stocks, not even remotely related to the innovation, to unsustainable levels.
There is widespread speculation during the later stages of a bubble. Investors buy assets not because of the assets’ earnings potential but because of their rapidly rising prices. Investors are captivated by the prevailing rosy narrative. Greed and the fear of missing out (FOMO) control their thinking and behaviour. Most importantly, they are convinced that these exciting times will last forever.
The genesis of financial bubbles lies in investors’ mad rush towards assets likely to benefit from the latest technological or financial innovation. Credit is usually the fuel that converts this mad rush into a rapid rise in asset prices. Credit is the most consequential factor in bubble formation. During economic euphoria, there is always someone to provide investors with easy, cheap, and abundant credit.
The credit flow that fuels a bubble is unlikely to come from traditional credit sources such as banks, bonds, or commercial papers. They most likely come from new institutional arrangements that circumvent existing financial regulatory and supervisory oversight.
Call money is a common type of credit used for stock market speculation. These loans are typically given for one day. Lenders provide call money loans to brokers, which brokers then forward to their clients to purchase stocks on margin. Here, investors’ own money will finance only part of their purchase, the rest is funded by margin loans.
A sharp drop in stock prices forces brokers to ask their clients (speculators) for additional margin money to hold onto their shares. If the client fails to provide them, the broker will be forced to sell the client’s shares in the market, putting downside pressure on market prices. Such large-scale selling could trigger a precipitous fall in stock prices.
Sometimes, brokers fail to recover the full margin loans from stock sales, causing a few or more brokers to go broke. The lenders who provided the brokers with loans will then suffer losses. The losses may cause lenders to turn risk-averse, severely restricting credit flow into essential parts of the economy.
Signs of economic slowdown could be visible even before the bubble bursts. This usually happens at the final stages of a bubble when economic euphoria and investor excitement peak. It is possibly because much of the capital that was supposed to go towards productive activities, such as consumption and business investment, got diverted towards speculation. This happens when large amounts of money are made in a very short time through speculation.
The rapid rise in asset prices occurs due to the continuous influx of new investors and capital into an asset. However, rapid price rises and new investor influx are mutually reinforcing. The rapid increase in asset prices attracts a deluge of new investors. These investors instigate another round of price increases, which further initiates another investor deluge. When one of them halts, the other one halts too.
The mutually reinforcing pattern is usually halted by a negative surprise or an adverse shock that punctures the prevailing, gimmick-fuelled, rosy narrative. A few professional investors start to become sceptical about the validity of the rosy narrative surrounding the latest fad or innovation. Slowly, the scepticism spreads to more investors, but still within the elite professional investor community.
These changes would be reflected in the asset prices through increased volatility and a failure for market prices to make or sustain new highs. But ordinary investors and the public remain oblivious to them. The general investor community acknowledges the bubble’s existence only when the bubble has burst, asset prices have fallen, and investor losses have mounted.
Disturbingly, most investors remain intransigent even if informed about the risks of a market bubble. It is nearly impossible to pinpoint the exact time the bubble will burst. Therefore, acknowledging a bubble before it bursts might require investors to sit on the sidelines and watch asset prices rise rapidly while others keep making money.
Nothing is more excruciating for equity investors than sitting on the sidelines and watching others make money. So, they keep dancing to the music, believing they could jump off the ship unharmed as soon as the music stops.
Unfortunately, most fail to execute the ‘jump ship’ plan in real time. The initial price declines are trivialised as small corrections in a long uptrend. Selling is painful now – that’s the point, as it clashes with investors’ entrenched belief in perpetual prosperity. So, they keep holding to the asset as its price keeps falling.
As prices continue to fall and losses accumulate, investors eventually reach a point where holding onto their losing positions becomes unbearable, making selling the only way to relieve the pain. This is the last phase of selling; prices fall sharply during this phase.
The dominant sentiment will be pessimistic when it ends. No one believes things will get any better soon. When the volatility subsides, we could conclude the bubble has largely deflated.
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