This week, we are going to talk about something different, something that is in the news everywhere, and that is bubbles, specifically an asset bubble or a speculative bubble.
Bubbles occur when prices for an asset rise exponentially over a period of time and get to a point well in excess of that assets intrinsic value. Generally, when this happens prices hit a wall and then they have the potential to fall very far, very fast if the bubble pops. Bubbles can occur in all kinds of assets stocks, real estate, collectibles, credit, commodities and currencies.
One of the most commonly talked about bubbles is stock market bubbles. Typically, these are driven by raw speculation and will begin to form when there is a gathering acceleration and price for an asset that far outstrips its intrinsic value, an example of this could be GameStop. A bubble occurs because people are willing to pay more and more for a security above and beyond normal expectations. There was a phrase that was popularized by a former Federal Reserve chairman, Alan Greenspan, which he called “irrational exuberance”. He used that to describe the collective enthusiasm among traders and investors that fuels rapidly increasing prices that outstrip the underlying fundamentals. Whether you call it crowd mentality, herd bias, the bandwagon effect or FOMO (fear of missing out), there is a self-perpetuating cycle where people want to buy an asset because its price is increasing, driving the price even higher and making even more people want to buy it.
It is important to note that not all periods of rapid price acceleration are bubbles. Following a recession or a bear market it is normal for asset prices to recover sharply, which we saw beginning in March of 2009 after the great financial crisis. Hope and speculation may have also fueled that rebound, as investors thought the worst of the market declines or economic slowdown were over. The key difference is that these price increases can ultimately be justified by fundamentals.
Most bubbles only become apparent in hindsight and you cannot say if you we are currently in one. So how do you protect yourself from bubbles within the market? The question is not how to time your way in and out of what might or might not be a market bubble, but to use some of those basic things that we always do, which are proper asset allocation and diversification,
and not concentrating your portfolio in one asset class or sector.
-Stay happy, stay safe stay well!
The CM Group