Behavioral finance FAQ / Glossary (Bubble / Crash)

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Dates of related message(s) in the
Behavioral-Finance group (*):

Year /month, d: developed / discussed,
i: incidental

(speculative) Bubble / Crash.




Seen in many messages, it is
a BF classic + see also cycle,

cascade, rational bubble, bull,
bear, overreaction, fad, herding,
hysteria, trend, dot.com + bfdef3

Boom and doom, the "wheel of fortune".

What are asset market bubbles and crashes?

Scarce but impressive rides.

Sure you want to commit money on them?

At variable time intervals, asset markets experience violent excesses
in price rises or falls
usually called bubbles and crashes.

Their frequency and time-span are not regular, but are measured in
years or decades.

This long drift translates into anomalous (negative or positive) returns.

This is just a mechanical effect as an element, in some cases the
main one of an asset return is its price rise or fall
(yes, this is
why a return can even be negative).

Well it can be less decisive  for bonds or for rented real estate, for
which regular incomes are essential..

It is hard to define quite precisely those phases of the market roller
coaster ride. But we might give tentative descriptions:

Bubble

A self-
perpetuating

and extreme
price rise.

 


A 50% rise usually belong to ordinary
bull markets
, not bubbles.

But if that first move is followed

by a price multiplication by
2, 3 
or more in a few year,

it was in retrospect a bubble take off.

Crash
.

A massive
often violent
price fall.


 


A 15% - 20 % dive can be labeled just 
as a "correction", not a full crash,

But a fall of 30% or more in a 
  
few months is a crash,

And one of 2/3 or more in a few
years
is ...the perfect crash.

Do they strike all markets in the same way?

Which markets get more seasick?


Stock markets gave blatant examples of such spectacular events

But as seen in the "famous historical occurrences" section at the end of
this article,
those extreme situations are not specific to stocks only.

They can hit any traded asset or investment (see "real estate
boom" for example).

Those phenomena could have been called "(hyper) inflation" and "(hyper)
deflation", but the words were already used by economists for consumer
prices.

Even so, let ust label them "extreme asset price inflation (or deflation)".


On the other hand, financial asset markets (stocks...) seems proner
to
persistent excesses than other markets
(commodities, foreign
exchange...).

Herding is very active in financial assets. People tend to salivate
at those goodies and to buy them when their prices rise, and to
distrust and sell them when they fall.


In commodity markets, on the contrary, the law of "offer and
demand" tends to work better, with more potential buyers at low
prices and more potential sellers at high prices.

Herding exists also but has a shorter life.

After a while price rises attract less "physical" demand and price
falls attract less physical offer.

On the other hand commiodities are more sensitive to economic
variations
, if only because supply is less elastic than demand, so
their prices also tend to ride a roller coaster

Bubble & crashes are two associated market

behaviors, with similarities and differences

Highs and lows in collective dopamine injections.

Bonanzas (bubbles) or shirt-losing (crashes), although
opposite in their results, have social behavior similarities.

They show, as confirmed by neuroeconomics and experimental
economics, that:

The human brain produces sometimes extreme reactions in

various situations.

This includes economic and financial market ones.

Those excessive behaviors can be contagious

and self-reinforced, as market players influence one another.

Also those two phenomena, bubbles and crashes seem to  

 alternate (after several years, and sometimes one or two
decades
).

A bubble is often followed by a crash, and then by another
bubble, and so on.

There is some analogy with a "cycle" (see that word) .

  But in reality, things are rather asymmetric:

Crashes are often more sudden, brutal (as instantaneous big price

drops), with less advanced signals, than bubbles.

But there are also rampant crashes and rampant bubbles,

Yes, some bear markets or bull markets extend sneakily for a
very long time before reaching their full effect.

Sometimes also, there are mere price stagnations without clear
   rise or fall.

Anti crash or anti bubble behavior!

Boring stuff for traders, all the more as volatility is low in such
cases!

Parallels and discrepancies between those
    
financial events and similar economic and
     monetary ones

Dance is everywhere:
the economy has its extreme swings also.

Outside finance, in other fields of economics, similar phenomena also occur:

When related to the volume of economic activity:

We have "business cycles" that can lead to "booms"
and "busts / slumps / recessions"

Economic booms and slumps are (usually) more diffuse, thus far-
reaching, events than financial bubbles and crashes.

They are periods of excessive economic growth or fall in
business activity, employment and incomes
.

On the other hand, the prices of most goods and services usually
do not change too much.

But this might happens also, in general, or at least in specific
sectors (commodities).


When the rise or fall is seen in consumer 

prices, we have inflation or deflation.

Those phenomena have also monetary traits: monetary expansion -
contraction, interest rate variations...

Those evolutions often go in the same direction than economic
activity (business cycles), but not always: for example a
"stagflation" is an inflation without economic growth.

Are those economic and financial phenomena
    interrelated?

Did the hen made the egg,
or did the egg made the hen?
Or did both came separately from outer space?


Financial bubbles and crashes are sometimes the cause or consequence
of economic or monetary cycles.

See below the "subprime" crisis in which the financial situation
and the economic situation moved nearly in unison, maybe because
a previous loose monetary policy caused at the same time wild
trading and over spending.

But this close relation is not always at play.

There is often some independence, no full correlation between
the financial sphere and the economic or monetary(*) sphere.

Even when there is a link, those evolutions are

rarely simultaneous  :

Investors are supposed to have a prospective mind, thus normally

the financial sphere anticipates the economic sphere evolutions,

But sometimes on the contrary financial markets react only after

the economy has started to move (underreaction).

(*) Interest rates (nominal or inflation adjusted) play a key

role on financial, monetary and economic cycles.

There is a flaw in the Keynesian idea that pouring low-cost money
always boost the economic sphere. It can instead feed mostly the

financial sphere.

But here again it is quite complex, as human reactions are the key.

When rates are low they can encourage either consumption, or
financial
speculations, depending on how people react.

What creates financial bubbles and crashes?

Is the illness physical? Or in the mind?


Those blatant events can be seen as excessive forms of market price
trends
, either bullish or bearish, that some analysts see as nearly natural
"cycles".

Various factors might intervene:

Changes in fundamentals might take a part.

Some crashes can simply reflect bad economic prospects which
investors anticipated too late,

They can also result from unforeseen and sudden exogenous
events (shocks). Examples often given are

* An oil price shock that alters the economic situations,

* A massive bank (or state) bankruptcy that menaces the
    whole
financial system,

* A dramatic political event (war, revolution, terrorist act)
  
with dire economic effects.


But previous speculative trend-following excesses

(leading to overpricing / underpricing) are usually the
main causes.

Greedy herds rising to the stratosphere
which turn into fearful herds falling to the abyss.

Most of the time collective behavioral excesses are at
play in bubbles and crashes.

We have then the behavioral contagions quoted above.

Trends may start because of "rational" expectations (see rational
bubbles) but after
a while greed and fear
mimicry
(see crowd / herding) can exacerbate them
(overreaction).

Often, that phase is a result of a "self-generated",

"mechanical" and "instinctive" form of crowd hysteria.

More rarely, and then limited to one or a few specific

asset(s), it reveals manipulations, such as intentional
pyramidal
schemes.

Both things might be linked, a general speculative mood
  
creates  fraudster vocations.


A technical accelerator is illiquidity (see "liquidity
    squeeze").

Here, too many potential buyers chase too few offered assets
(bubble), or on the contrary too many assets offered face nearly
no potential buyers (crash).

In such cases a very important price variation is needed to match
offer and demand.

For example, in stock markets it seems there are three
phases
in a crash, or more generally in a bear stock
market

1) A first bout of uncertainty and fear with some selling

(bear market) or sometimes panic selling (crash),

2) A long downwards period (it can last for several years)

with a shortage  of buyers but less sellers also, loss
aversion and underreaction make them "resist".

There are even temporary recoveries (bear rallies),
which can
trap some buyers.

3) A capitulation (see that word) where those who did 
      
not sell become in their turn panicky, overreact at
       the end and sell massively,

This can signal that the real recovery is imminent.

Famous historical occurrences

A museum of economic / financial crazes
and hands-wringing.

History has shown that price bubbles / crashes can happen in any asset
class
:

Currencies, commodities, bonds, bank credits, interest rates, financial
derivatives, mutual funds, real estate, art and collectible markets...and
of course, stock markets.

Among famous cases in history, we can cite:

The tulipomania in Holland in the 18th century,

The 1929 crash in the New York Stock Exchange that spread

to the whole world financial and economic system,

The dotcom bubble at the turn of this century (see "story"),

Nowadays (2007- ...) the US-originated
   "
subprime crisis" (or "toxic debt" crisis)

It was caused by lax monetary and credit policies and to related
"exotic" financial practices,some of them verging on deception.

It spread worldwide and affected at the same time, in many
places:

* Real estate,

* Banking (with massive losses and a credit crunch and 
   liquidity 
squeeze, see that phrase),

* The stock market and the Forex (foreign currency exchange).

The menace of a "systemic crisis", such as a general financial
collapse, 
was averted through massive
injections of new
money, notably by the US
authorities.

Those injections might have their own perverse
effects
(on sovereign debts, on the world monetary
system, even if  deeper causes are at play here).

On the economic front, in 2008 a global economic recession
started to hit many countries and industries.

Monetary laxity, real estate excesses, financial blunders and
various economic imbalances seemed to converge into the
"perfect crisis"
.
In 2014, still nobody is certain of a sustainable recovery.

This is one of the cases in which the financial sphere and the
economic sphere evolved in unison.

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

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This page last update: 17/07/15   

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