Much has been made of bubbles in recent years. The late 1990’s saw the technology bubble, quickly followed by a real estate bubble that resulted from easy-money policies designed to stimulate recovery from the technology recession. Each time that a bubble emerges, it follows a relatively consistent pattern. Dr. Jean-Paul Rodrigue from Hofstra University separates bubbles into four phases: The Stealth Phase, the Awareness Phase, the Mania Phase, and the Blow off Phase.

Stealth Phase
This is the period when a bubble has not yet formed when the “smart money” realizes that a rapid escalation in market values is likely. Many of the people who are involved at this phase are involved in venture capital or some other type of speculative investment that attempts to spot a few big winners in the midst of many average investments. The stealth phase ends when an asset starts to rapidly escalate in value.

Awareness Phase
As more people become aware of the escalating prices for the asset in question, awareness begins to build and fund managers start to take notice. As the buying continues, there is typically a point when the original investors sell-off their stake to take their profits. The dip in values regresses back to where it was before the sell-off and attracts mainstream media attention.

Mania Phase
Once there are specials on 60 minutes about an investment, you can be certain that it has entered the mania phase. This is the point when part-time “investors” make more money speculating then in their primary occupation. The mania phase is characterized by a rapid rise of values that induces more people to buy in anticipation of further rises in value. This process propels market values up to unreasonable and unsustainable heights until people begin to announce the emergence of a new paradigm or new economy where values always go up. This is almost always when the sell-off begins.

Blow off Phase
At the point when prices reach their ultimate unsustainable high, there ends up being a shortage of buyers who are willing to pay increasingly high prices and the market values drop. When people see the sell-off, they race to lock-in profits and sell, which drives the price down further. After an initial drop, there is frequently a subsequent upward blip from buyers who think the market is returning “back to normal” and that the bubble will resume.

Unfortunately, there is still a shortage of people willing to pay escalated prices, and a fear-based sell off begins. At first, it’s from people wanting to lock-in their profits, and then it shifts to people who want to avoid taking a loss, and finally it moves to people who have already lost and want to avoid going bankrupt. Eventually this sell-off frenzy pushes prices below their fundamental level.

At this point, investors begin to realize that the asset is under-priced relative to its fundamentals and begin buying. This pattern pushes prices back toward their fundamental value. In many cases, the people who got out before the bubble began to escalate are the same ones who buy back in after it collapses. Understanding the formation and destruction of price bubbles is the way that investors can join the “smart money” who capitalizes on these irrational price movements.

From an economic perspective, bubbles represent a terrible misallocation of capital. Every dollar that is spent chasing imaginary profits from an asset bubble is a dollar that does not get spent in some other form of productive endeavor. When aggregated together, this results in a massive over-investment in things like residential housing while other economic sectors encounter massive under-investment. Recessionary price adjustments are a natural and necessary way of re-allocating this capital so that it serves a productive use. The over-valued assets must be sold at a discount to attract investors who will use them productively. Many of the people involved in building and selling these assets must find other means of earning a living since there is no longer a frenzy of buyers who can finance their salary.

As astute investors, it is critical that we stick to fundamentals. Ultimately, this means investing in real products and services that are made for and sold to real customers. Whenever the basis of an investment strategy revolves around constantly escalating market prices from an opaque third party, there is reason to be cautious. By focusing on things like cash flow from customers, it will help to naturally avoid the frenzy that drives and ultimately destroys market bubbles.

Action Item: Invest based on fundamentals, and avoid chasing bubbles like the masses. This will provide the wisdom and insight to buy when values are artificially low, and sell when the price is no longer justified by the fundamentals. Attempting to profitably time market bubbles is an extremely risky proposition that holds great danger for all but the most lucky/skilled. (Is there really a difference?)

The Jason Hartman Team

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