🫧What is an Asset Bubble?

Market bubbles occur when there is an extreme separation between the price and value of an asset. This creates a fragile economy that can crash at any moment. The higher asset prices rise above the true asset value, the more fragile the market becomes.

There are four stages to a bubble that we must know. Understanding these stages keeps us from falling victim to a crash that can strip our wealth away.

The 4 Stages of a Market Bubble

We will reference the Dot-com bubble of 2000 and the housing crash of 2007 as references.

1. Stealth Phase

   A new product or technology is developed and/or a new policy or deregulation is created. This leads to new opportunities for investment and cash to flow easily through the market.

   🛜 Dot-com Bubble: The internet was invented in 1983. There were 16 million internet users in 1995.

   🏠 Housing Crash: The Tax Payer Relieve Act of 1997 allowed homeowners to excluded capital gains of $250k ($500k if married). In 1999, Fannie Mae increased subprime loans.

2. Awareness

   This is where the impact of the catalyst (the new product, technology, or policy) become evident to the public. Investors adopt the trend as an opportunity to make above average market returns.

   🛜 Dot-com Bubble: By 1996, there were 45 million internet users. An increase of 181% in one year!

   🏠 Housing Crash: By 2002, Fannie Mae and Freddie Mac extended more than $3 trillion worth of mortgage credit.

3. Mania

   This is when our psychology kicks in and turns us into victims. Financial media is constantly hyping the catalyst as the next big thing. The hype and euphoria take over and investors are overly optimistic about the future of the market. There’s a widespread adoption of a “new paradigm”.

   The fear of missing out (FOMO) drives us to chase the market surge.

   The tricky part is this: Corporate revenues and/or profits are growing at an insane rate! 
   

   It’s confusing for many. The catalyst appears to be a sure win due to the amazing growth companies experience during this time. There is usually one industry or a select few stocks that climb ahead of the rest.

   🛜 Dot-com Bubble: Cisco was the company making the networking equipment that enabled much of the internet.

   🏠 Housing Crash: The increased demand in buyers drove housing prices up. Mortgage-backed securities become the asset of choice of commercial investors.

   Does this sound familiar when thinking of the euphoria surrounding Nvidia?

4. Downfall

   This is when that left-hook you should have seen coming hits you square on the chin. 🥊

   The companies that experience exponential growth and productivity that spur a bubble can’t keep growing at those astronomical levels.

   Often, the growth continues at a solid rate. But 15% sounds horrible when you desire another 50%+.

   Investors begin to sell their stocks, securing profits in hopes of not being a victim to the bubble.

   🛜 Dot-com Bubble: The market peaked in August 2001 and didn’t recover until December 2006. Unfortunately, the housing crash was right around the corner.

   🏠 Housing Crash: The housing bubble began to crumble in September 2007. The market didn’t surpass its 2007 levels until January 2013..

2000-2010 ended up being The Lost Decade due to the market producing negative returns.

The four words that killed the most wealth: “It’s different this time.”

Far too often, it is in fact, not different.

Here’s how to Avoid falling victim to a bubble

Don’t try to justify the bubble.

We have a bias to be hopeful with investing. After all, we are only investing because we believe our money will grow. However, we must always be mindful of the threats and risks of the market.⚠️

The denial is what kills your wealth.

Don’t chase stock surges.

When you hear about a stock surge, its often to late to jump in. There are times where it’s prolonged and there is still opportunity. If that’s the case, carefully plan your entry and exit strategy so that you’re not left holding the bag when the surge is over.👜

If you are on a wave, there’s nothing wrong with riding it.

If you happen to own a stock that is surging. Don’t rush to jump ship. I understand you may think its overvalued but it is smart to “go with the trends” if something like this happens. Many people spend their time anticipating momentum, hoping to get in front of the next surge. If you’re lucky enough to already own a surging stock, don’t panic and think you automatically have to take action. Nothing wrong with riding the wave. Make decision to continue holding long-term or come up with an exit strategy. 🌊

Don’t invest without regard to fundamentals.

When buying stocks, ALWAYS respect the fundamentals of the business. 📊

What is the expected growth rate of the market they compete in?
How much have revenue and earnings grown in the past five years?
How much are they expected to grow in the future?
Is the balance sheet healthy?

Check my YouTube videos where I break down various companies exploring these questions and more. ⬇️

Tweet of the Week!