The Anatomy of a Crash
A closer examination of asset price bubbles reveals that the behavior of markets often follows a common pattern that comprises at least four stages:
A common ingredient in market bubbles, innovations are often based on concepts that are difficult for a lay person to understand, like the information technology boom, or the biotech bubble at the end of the 1990s. Investors cannot assess the true potential of an innovation for a company’s earnings growth or productivity. Innovation in a favorable economic environment increases company earnings, but these initial successes may ultimately have limitations that may be unknown to investors. Since no historical evidence is available about possible risks, market participants may underestimate risks and project excessively high initial growth rates, ignoring the inherent limitations of growth for a new technology.
In a second stage, the presumed benefits of innovation and a new economic era are increasingly overestimated. Prices of stocks or houses continue to rise steadily and markets tend increasingly to ignore risks. Often, risks are only acknowledged after they materialize in the real world. This is the time when euphoria begins and investors clamor to get into the market “because prices can’t go down” and “this time it’s different,” or “this is a new era.” High profits attract new investors, and this in turn leads to higher returns as cash pours into these markets. A lack of liquidity in the markets may lead to further exuberance when demand becomes much bigger than potential supply. Especially in illiquid assets like houses, short-term demand can drive prices far from fundamentally justified values.
The positive feedback loop cannot last forever. At some point fundamental forces lead to a trend reversal. The result is often a rapid and steep decline in asset prices as the bubble bursts and the market crashes. The consequent loss in wealth can lead to lower consumption or investments in the real economy and can even destabilize the financial system. The effects can include recessions, or banking and currency crises as we witnessed in 2008. Here, a lack of liquidity can increase the fall in asset prices when sellers want to unload their investments at any price and illiquid investments may have to be sold at the worst possible time. In the financial crisis of 2008 it was the forced selling by hedge funds, private equity funds, and other investors that partially contributed to the sell-off of stock markets in the second half of 2008.
A crash frequently is followed by increased regulation to prevent similar events from happening again. It is interesting to note that as a result of regulation and the lessons learned from a market crash, the exact same events are indeed very unlikely to recur and financial market stability is increased. But, as time passes, the positive effects of regulation fade. Market participants tend to forget about the causes and consequences of past bubbles. Who today considers the lessons of the go-go years of the 1960s, or even remembers them? Every generation can repeat the mistakes of previous generations, as is confirmed by the emergence of bubbles roughly every 20 to 30 years.
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