Interesting discussion about bubbles from Investopedia:

Five Steps of a Bubble
Minsky identified five stages in a typical credit cycle – displacement, boom, euphoria, profit taking and panic. Although there are various interpretations of the cycle, the general pattern of bubble activity remains fairly consistent.

  1. Displacement: A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low. A classic example of displacement is the decline in the federal funds rate from 6.5% in May, 2000, to 1% in June, 2003. Over this three-year period, the interest rate on 30-year fixed-rate mortgages fell by 2.5 percentage points to a historic lows of 5.21%, sowing the seeds for the housing bubble.
  2. Boom: Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be an once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of participants into the fold.
  3. Euphoria: During this phase,caution is thrown to the wind, as asset prices skyrocket. The “greater fool” theory plays out everywhere.Valuations reach extreme levels during this phase. For example, at the peak of the Japanese real estate bubble in 1989, land in Tokyo sold for as much as $139,000 per square foot, or more than 350-times the value of Manhattan property. After the bubble burst, real estate lost approximately 80% of its inflated value, while stock prices declined by 70%. Similarly, at the height of the internet bubble in March, 2000, the combined value of all technology stocks on the Nasdaq was higher than the GDP of most nations.During the euphoric phase, new valuation measures and metrics are touted to justify the relentless rise in asset prices.
  4. Profit Taking: By this time, the smart money – heeding the warning signs – is generally selling out positions and taking profits. But estimating the exact time when a bubble is due to collapse can be a difficult exercise and extremely hazardous to one’s financial health, because, as John Maynard Keynes put it, “the markets can stay irrational longer than you can stay solvent.”Note that it only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot “inflate” again. In August, 2007, for example, French bank BNP Paribas halted withdrawals from three investment funds with substantial exposure to U.S. subprime mortgages because it could not value their holdings. While this development initially rattled financial markets, it was brushed aside over the next couple months, as global equity markets reached new highs. In retrospect, this relatively minor event was indeed a warning sign of the turbulent times to come.
  5. Panic: In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate them at any price. As supply overwhelms demand, asset prices slide sharply.One of the most vivid examples of global panic in financial markets occurred in October 2008, weeks after Lehman Brothers declared bankruptcy and Fannie Mae, Freddie Mac and AIG almost collapsed. The S&P 500 plunged almost 17% that month, its ninth-worst monthly performance. In that single month, global equity markets lost a staggering $9.3 trillion of 22% of their combined market capitalization.

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Hat tip JB

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Source:
5 Steps Of A Bubble
Investopedia Staff
San Francisco Chronicle, June 2, 2010

http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2010/06/02/investopedia5751.DTL

Category: Markets, Psychology

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3 Responses to “Anatomy Of A Bubble”

  1. Low Budget Dave says:

    you forgot:

    6. Search for the guilty.
    7. Punishment of the innocent; and
    8. Rewards and praise for the non-participants.

    (I think this is a quote from Ashleigh Brilliant, but maybe not.)

  2. b_thunder says:

    “…but once it is pricked, the bubble cannot “inflate” again.” – would someone PLEASE show this to the “Helicopter” Ben, Teflon Timmy, and the certified-genius-from-the-age-of-3-years-old Summers?

  3. davossherman@gmail.com says:

    Missing 2 stages:

    Link: http://www.pacificviews.org/weblog/archives/003679.html

    Full:

    MINSKY’S EXPLANATION OF BUBBLES
    Many financial articles discussing the financial crisis mention Hyman P. Minsky, an economist from a quarter of a century ago, and his insight into asset bubbles. When he wrote his observations and conclusions about the types of problems that could arise from financial deregulation, just as the Chicago boys were getting their chance to change the world, he was scorned for his warnings. Yet, since that time, we’ve had three substantial financial bubbles, the last of which we will spend years unwinding. Thus it might be good to have a broader understanding of what insight Minsky had in order to make sure we don’t set off another asset bubble that finally does our world in.

    I found a very good summary of the seven steps of an asset bubble on a forum thread that helps explain the situation:

    The late Hyman Minsky knew that there was nothing new under the sun. If he were alive today, he would have understood exactly the dilemmas raised by today’s explosive growth in real estate prices. Minsky developed a simple universal framework for understanding all bubbles. The circumstances of each bubble may differ, but each one goes through seven stages.

    Stage One – Displacement

    Every financial crisis starts with a disturbance. It might be the invention of a new technology, such as the internet. It could be a shift in economic policy. For example, interest rates might be reduced unexpectedly. Whatever it is, the world changes for one sector of the economy. People see the sector differently.

    Stage Two – Prices start to increase

    Following the displacement, prices in the displaced sector start to rise. Initially, the price increase is barely noticed. Usually, these higher prices reflect some underlying improvement in fundamentals. As the price increases gain momentum, people start to notice.

    Stage three – Easy Credit

    Increasing prices are not enough for a bubble. Every financial crisis needs rocket fuel and there is only one thing that this rocket burns – cheap credit. Without it, there can be no speculation. Without it, the consequences of the displacement peter out and the sector returns to normal.When a bubble starts, the market is invaded by outsiders. Without cheap credit, the outsiders can’t join in.

    Cheap credit is the entrance ticket for outsiders. For example, gas prices have risen sharply in recent years. However, banks aren’t giving out loans so that people can store gas in their garages in the hope that the price will double in three months. The banks, however, are prepared to give loans to people with poor credit to hold condos in the hope that they can be quickly flipped.

    The rise in easy credit is also often associated with financial innovation. Often, a new type of financial instrument is developed that miss-prices risk. Indeed, easy credit and financial innovation is a dangerous cocktail. The South-Sea Bubble started life as new-fangled legal innovation called the limited liability joint stock company. In 1929, stock prices were propelled into the stratosphere with the help of margin calls. Housing prices today accelerated as interest-only mortgages emerged as a viable means for financing overpriced real estate purchases.

    Stage Four – Over-trading

    As the effects of easy credit kicks in, the market starts to overtrade. Overtrading stimulates volumes and shortages emerge. Prices start to accelerate, and easy profits are made. More outsiders are attracted, and prices run out of control. Accelerating prices attract the foolish, greedy and the desperate to enter the market. As a fire needs more fuel, a bubble needs more outsiders.

    Stage five – Euphoria

    The bubble now enters its most tragic stage. Some wise voices will stand up and say that the bubble can no longer continue. They put together convincing arguments based upon long run fundamentals and sound economic logic. However, these arguments evaporate in the heat of the one over-riding fact – the price is still rising. The wise are shouted down by charlatans, who justify insane prices by the euphoric claim that the world is different and this new world means higher prices.

    Of course, the “new world” claim is true; the world is different every day, but that doesn’t mean that prices run out of control. The charlatan wins the day and unjustified optimism takes over. At this point, the charlatans bolster their optimism with the cruelest of all lies; when prices finally reach their new long run level, there will be a “soft landing”. The idea of a gentle deceleration of prices calms the nerves.The outsiders are trapped in knowing denial. They know that prices can’t keep rising forever, but they rarely act on that knowledge. Everything is safe so long as they quit one day before the bubble bursts.Those that did not enter the market are stuck in a terrible dilemma. They can not enter but neither can they stay out. They know that they have missed the beginning of the bubble. They are bombarded daily with stories of easy riches and friends making massive profits. The strong stay out and reconcile themselves to the missed opportunity. The weak enter the fire and are damned.

    Stage Six – Insider profit taking

    Everyone wants to believe in a new brighter future but a bubble takes that desire and turns it upside down. A bubble demands that everyone believes in a brighter future, and so long as this euphoria continues, the bubble is sustained.However, as madness takes hold of the outsiders, the insiders remember the old world. They lose their faith and start to panic. They understand their market, and they know that it has all gone too far. Insiders start to cash out. Typically, the insiders try to sneak away unnoticed, and sometimes they get away with it. Other times, the outsiders see them as they leave. Whether the outsiders see them leave or not, insider profit taking signals the beginning of the end.

    Stage seven – Revulsion

    Sometimes, panic of the insiders infects the outsiders. Other times, it is the end of cheap credit or some unanticipated piece of news. But whatever may be, euphoria is replaced with revulsion. The building is on fire and everyone starts to run for the door. Outsiders start to sell, but there are no buyers. Panic sets in; prices start to tumble downwards, credit dries up, and losses start to accumulate.

    Here is the paradox of all bubbles – everyone knows how the fatal combination of easy credit, overtrading and euphoria will affect prices. Minsky didn’t need to write down a thing about the madness of speculation. America’s investors have a lifetime of experience. Within the space of five years, America moved from the tech stock bubble into the real estate bubble.Today’s housing prices are grossly overvalued. Everyone knows that prices will collapse. It might be tomorrow, or it might be two years from now. One thing, however is certain, the longer it takes for the bubble to burst, the more painful it will be.