The Myth About Market Bubbles

By Brian Bloch AAA

At various points in time, policy makers, bankers, brokers and sundry others claim that bubbles can only be identified after they burst. "You can't see them when they are developing," they say – and this is just not true.

What Is a Bubble, Exactly?
In the simplest terms, a bubble is an overheated market in which there are too many buyers who are too keen to buy. As a result, prices rise way too fast, and this situation becomes unsustainable. Eventually, some people realize this and start to sell out. The whole process goes into reverse equally rapidly, and the bubble bursts, with people selling in panic so that prices plunge. Particularly those who entered the market late in the process suffer substantial losses. (For a background reading, see our Market Crashes Tutorial.)

The Alleged Invisibility of the Bubble
Some bubbles are certainly more visible than others, and some people are in a better position to see them than others. But all bubbles are identifiable, and the process described in the paragraph above is not invisible to the naked eye.

In extreme cases, people may even be seen wearing t-shirts bearing such messages as "The Property Market Bubble: Will It Burst?" In the stock markets and many others, simple price rises and various more complex ratios and indicators can be seen to change unhealthily. In property markets, there are reports of prices increasing by 5% (or even much more) in one month. Other, less publicized markets, such as those for bonds, certain commodities and currencies, may not be so obvious, but there will be indicators.

Whatever the market, even simple charts, basic patterns of buyer or seller behavior and media reports reveal radical changes within a short time frame. These are clear danger signs. (To learn more, see Economic Indicators For The Do-It-Yourself Investor.)

In other words, if you look for signs of overheating, they are there. Professionals in the field, such as bankers and brokers, do know about the state of the market. And if they really don't, they should be in some other line of work. Euphoric investor behavior and all those other radical changes mentioned above will certainly not go unnoticed. This occurs, for instance, when people come in to the office saying that their friends have made a packet and they don't want to miss out.

In short, for someone working in the investment industry every day to claim that "no one could see it coming" is absurd and outrageous. Of course, there can be exceptional situations that burst bubbles prematurely or very late, but generalized allegations that a bubble was out there lurking invisibly behind the scenes from start to finish are just plain false.

Why Are There These Claims of Invisibility?
The basic problem is that there is money to be made out of a bubble, particularly on the selling side. A bubble is really a great thing for the financial services industry. They can sell of lot of the bubbling asset for substantial gains, and when the bubble bursts, it is the investors who lose out, rather than the seller.

However, the seller does have a problem in that the buyer who is sitting on losses may complain and want compensation. Few brokers will own up, apologize and fork out tens of thousands of dollars or more. Instead, they will say that one could not see the bubble at the time.

Likewise, politicians and other policy makers who should have being regulating or monitoring the markets (but did not) will make similar claims. It costs nothing to hide behind this defense, and who wants to admit that they were asleep at the wheel or not looking out the window?

Getting Out Before the Burst
The financial services industry wants to carry on making money as long as they can. And indeed, it is very hard to time the exact timing of the burst. So, sellers tend to keep quiet until too late.

Investors themselves sometimes get greedy and therefore do not sell when they should. However, this is naïve greed, because, as the saying goes "no one ever went broke from taking a profit". Trying to stay in a red hot market till the peak is not only dangerous, it is one of the worst and most imprudent of all risks. When such markets drop, it is alarmingly rapid and generally too late to exit without big losses. (Learn more in Riding The Market Bubble: Don't Try This At Home.)

Other investors simply rely on their brokers to warn them, and, for the reasons given above, the warning may never come at any point. All too often, trusting private investors only know the bubble has burst on them personally, when the regular report arrives in the mail and the losses are plain to see. Many private investors are blissfully unaware of market developments, but, for all intents and purposes, no professionals who work in and with these markets from day to day can make such a claim. (See Four Big Investor Errors for more.)

As for the regulators and policy makers, they do not want to rock the boat, so they just let it all carry on. After all, everyone seems to be benefiting, so what's the problem? Such individuals can make themselves very unpopular with the industry by trying to cool down a sizzling money-machine. And after all, perhaps the bubble will burst after they leave office. (For more, check out Financial Regulators: Who They Are And What They Do.)

Solutions
You need to find honest brokers and sellers who will really take action when markets get overheated. There is no reason not to ask them if they have done this in the past.

Monitor the markets yourself. As always, you care about your own money infinitely more than anyone else does. Information, knowledge, understanding and willingness to ask are critical to avoiding being scalded by burst bubbles. It is generally advisable to periodically unwind holdings as markets rise, so as to keep asset allocations stable and to avoid overexposure to risk.

Regarding regulators and powers that be, this is very much their job. But don't count on them too much either.

Conclusion
Bubbles are inherent to financial markets. They will always develop and always burst, leaving behind big losses for many participants, particularly latecomers. Unfortunately, the tendency for sellers to ignore bubbles is also inherent, because it suits them, certainly at the time.

However, prudent and informed investors can and must watch for bubbles, and get out while the going is good. New investors should stay away and are entitled to a fair warning from sellers. Naturally, if people want to take big risks, that is their business, but they must really want to. (To learn more, see Is Your Broker Acting In Your Best Interest?)

You May Also Like

Related Articles
  1. How Advisors Can Help Clients Stomach ...
    Investing Basics

    How Advisors Can Help Clients Stomach ...

  2. Where NOT To Invest in Latin America
    Economics

    Where NOT To Invest in Latin America

  3. (Un)Mapping the Trend
    Charts & Patterns

    (Un)Mapping the Trend

  4. Technical Analysis Strategies for Beginners
    Trading Strategies

    Technical Analysis Strategies for Beginners

  5. The Beginning Of A Bear Market?
    Economics

    The Beginning Of A Bear Market?

Trading Center