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How to survive a stock market bubble
Brian Perry, Investopedia | April 18, 2009
In almost all instances, the root cause of a financial crisis is an asset bubble. But how does this bubble form, what finally causes it to pop and how can investors profit before it goes bust?
In order for a market to attain the excessive valuations necessary to prompt a crisis, a prolonged period of price appreciation combined with a large number of new entrants to the market is usually necessary. Read on to learn more.
Crisis in the making
However, at some point, so much money flows into the market that valuations exceed even those justified by attractive fundamentals, signaling the end of a bull market and the beginning of a bubble. Bubbles are fueled by the collective greed of investors. When this greed turns to fear, a crisis can ensue as investors rush to sell their holdings in a declining market.
Frequently, more than one of the factors are present, and each of the factors can be heightened by another.
Both of these firms were highly dependent on short-term financing to conduct their operations. However, the assets that they held proved to be illiquid during the credit crisis, and were therefore effectively long-term in nature. This mismatch between the firms' assets and liabilities directly contributed to their bankruptcies.
However, the problem becomes particularly acute when financial institutions employ excessive leverage. Excessive leverage exacerbated the asset/liability mismatch at Bear Stearns and Lehman Brothers and was also the main cause of the Long-Term Capital Management collapse in 1998.
In another famous example, Long-Term Capital Management believed that its portfolio held little risk because each of its trades was individually offset by other trades. However, when extraordinarily high volatility hit the financial markets in 1998, all of LTCM's trades began to move in the same direction, prompting massive losses and fears of a systemic financial collapse.
In all these instances, the governments had issued bonds or received loans denominated in foreign currencies. When the countries' currencies began to decline in value, the cost of repaying the foreign currency debt increased dramatically, prompting a crisis.
Economic impact of financial crises
On the other hand, some financial crises have caused severe economic damage. The Japanese equity and real estate market declines that began in 1990 ushered in a deflationary period in Japan, and sub-trend growth that persisted for nearly two decades.
Although the recovery from the 1997 Asian financial crisis occurred fairly rapidly, the short-term damage was extremely severe. In the year following the crisis, GDP growth contracted by 13.1 per cent in Indonesia, 7.3 per cent in Malaysia and 10.5 per cent in Thailand.
Unfortunately, there is no obvious reason as to why some economies suffer following a financial crisis while others do not. However, there is a large body of research on how to mitigate the effects of a financial crisis and it seems very likely that by minimizing the severity of the crisis, policy makers can improve the chances that the broader economy will not be severely damaged.
Preventing and mitigating financial crises
Providing the financial system with adequate liquidity: During the 2008 credit crisis, the Federal Reserve and other global central banks repeatedly lowered interest rates and provided extraordinary levels of liquidity to the financial system.
Establishing confidence in the safety of the banking system: This prevents consumers from rushing to the bank to withdraw their deposits. Confidence can be secured by providing government guarantees on bank deposits; in the US this guarantee comes in the form of the FDIC insurance program.
Reacting to a crisis
How can investors navigate financial crises?
It is difficult to avoid buying into a market bubble. No one likes to watch from the sidelines while everyone around them makes money, but history has shown again and again that market bubbles always burst. Some investors may have impeccable timing and be able to ride the bull to its apex before selling at just the right moment. However, these fortunate souls are rare, and their unique talent is probably not a successful recipe for the average investor.
While the growth of bubbles usually occurs over time, crashes can occur with stunning rapidity. During these times, the sense of fear in the marketplace can become so palpable that is easy to understand why some crashes have been labeled "panics." Sometimes, there may be a solid fundamental reason to sell into a panic.
If short-term trading is not part of one's strategy, and the holdings that are declining in value constitute only one part of a well-diversified portfolio, most investors would be wise to withstand the urge to sell.
The bottom line
Brian Perry is vice president and investment strategist at an asset management firm and an accomplished author and public speaker. He has published several articles and is a frequent presenter for several professional associations. Brian received a bachelor of science degree in finance from Villanova University in 1996, an MBA in International Business from National University in 2006, and is pursuing a master's degree in international affairs from Tufts University. Brian is also a candidate in the chartered financial analyst (CFA) program, has previously held Series 7 and 63 securities licenses, and taught an introductory class on investing at the International Center in New York City.