All you wanted to know about Market bubbles

Hari Vishwanath | Updated on January 11, 2021

Stock market indices are reaching all-time highs in 2020 in the midst of the worst global recession since World War II. There’s a chorus from fund managers and stock market analysts telling you that this is a bull market that has long way to go, with a V-shaped recovery just starting. You may also have heard the stray view that this rally is a bubble. Have you wondered what they are referring to and why?

What is it?

Nobel Laureate and economist Robert Schiller defines a bubble as market phase that ticks the following boxes. One, a situation in which news of price increase spurs investor enthusiasm. Two, it spreads by psychological contagion from person to person. Three, in the process, it amplifies stories to justify the price increases. Four, it draws in a wider class of investors. Despite doubts about the real value of the investment, they are drawn to it, partly through envy of others’ successes and partly through gambler’s excitement.

In short, a bubble is the stage of a market cycle where asset prices rise to irrationally high levels completely disconnected from the fundamental value of the underlying assets. In the process, they lure large numbers into the game in the hopes of making quick money.

Why is it important?

Like Icarus who flew too close to the sun for his own good ignoring the warnings of his father and consequently fell into the sea, all market bubbles after reaching irrationally high levels, inevitably crash. As they implode, they cause wealth destruction and it takes years to recover from the subsequent economic damage. You may have heard of the dotcom bubble of 2000 and housing bubble of 2007. Developed economies slipped into recession followed by emerging economies.

Hence like Icarus who should have heeded his father’s warning, it is important to heed market experts when they say a stock market rally is a bubble.

Why should I care?

Because it involves your wealth. If you were invested in India’s benchmark index – Nifty 50 at the peak of the dotcom bubble, you would have lost 50 per cent of your wealth by the time the index bottomed 18 months later. If you were invested in Nifty 50 at the peak of the housing bubble of 2007, you would have lost 60 per cent of your wealth 14 months later. Nifty 50 again crossed its 2007 peak only in 2014.

But spare a thought for the Americans or the Chinese. The benchmark index for US tech stocks — Nasdaq Composite took 15 years to get back to the level it reached at the height of the dotcom bubble. The Chinese as of today have still clawed back to only 60 per cent of the index levels after their main index — SSE Composite peaked in 2007. But the Chinese can take inspiration from the never-give-up attitude of the Japanese. The Nikkei has clawed back to 73 per cent of its peak value today, a full 31 years after its stock market peaked in 1989.

All this if you had invested in the index which is a basket of diversified stocks. If you had invested individually in some of poster-childs of each bubble, like real estate stocks in India in 2007, you would have lost much more of your money and permanently.

So, if you find everyone around you talking about stocks, analysts crystal-gazing far into the future, or all your friends and neighbours minting money in markets, those a sure signs of a bubble brewing.

The bottomline

If Icarus was warned not to fly too close to sun, the market equivalent is — don’t chase quick profits with speculative trades.

A weekly column that puts fun into learning

Published on January 11, 2021

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