The 5 stages of a market bubble

Adit Kashyap | April 9th, 2022

An economic bubble can be defined as an economic phenomenon where an asset’s price rises dramatically without any significant appreciation in the use of that asset. In simpler words, it’s when the value of an asset rises even though it or what it represents hasn’t become more useful.

Bubbles have existed for a very long time and have come in several shapes and forms. It can revolve around stocks, real estate, cryptocurrency, and even tulips!

In this article, we will take a look at the 5 different generally agreed-upon stages of an economic bubble.

The following are the 5 stages of an economic bubble with a brief description of each.

Displacement: The arrival of a new concept (new paradigm) that is in stark contrast with the old ways of doing things and is more attractive.
Boom: The slow rise in the price of an asset due to the displacement, followed by a booming growth rate as more and more investors line up to make profits.
Euphoria: This is when investors trade the concerned asset with excitement and irrationality, without any insight into the actual value and use of the asset but only with the hope that its price will continue to rise and provide greater profits to them once it is sold.
Profit-taking: This is the stage where experienced and seasoned investors, who invested in this asset, begin to foresee the bursting of this bubble and start selling their assets to make a profit.
Panic: This is the final stage of an economic bubble. The bubble bursts, the asset loses value, and people frantically sell their assets in a bid to make salvage something or the other.

Now, we will go into greater detail about each stage.

Graphical representation of the effects of the dotcom bubble on NASDAQ Composite.

Displacement

Displacement is a phenomenon that occurs when investors are fascinated by and attracted to a new paradigm i.e, a new way of doing things that differs from its older counterpart/s and seems to be the way to the future. A good example of a new paradigm is the internet. It was a revolutionary invention and it has totally changed the way we live today.

Despite being such a success, however, it was also a victim of investor hype. Several investors were caught up in the hype surrounding the internet and its perceived present and future uses. This resulted in the overvaluation of a number of equities and stocks of internet companies. In essence, investors were piling money into internet companies only with the hope that they will be able to turn a profit from these internet companies, not because these companies were actually providing something useful. This was what laid the groundwork for the dot com bubble.

Boom

This is the stage when an asset that causes displacement and is starting to pick up value. At first, the asset picks up value pretty slowly but as the hype around the displacement it has brought about increases, so does its momentum. News about such displacement gets around and people become more and more interested in such assets. These assets receive a tremendous amount of media coverage, from small-time podcasts to large, established news companies.

Due to the immense amount of hype surrounding the asset, people fear missing out the opportunity to cash in. This fear is so profound that people don’t take the time to do minimal research into the asset in question in order to truly find whether it or what it represents is actually useful and will turn out to be a good investment. Such an influx of new and ill-informed investors results in the value of the asset skyrocketing, setting the stage for more profit-hungry investors to enter the market and contribute to the inflation of this bubble.

Euphoria

This is the stage where most investors stop caring anymore. All they see are the huge green candle bars and upward-facing lines on the charts of the value of these assets. All investors want to do now is make more and more money, without ever stopping to think whether any of this is sustainable and good for their money. It is at this stage that the greater fool theory comes into play.

In essence, the greater fool theory stipulates that the price of an asset or commodity keeps rising as it can sold to another person at a higher price than at which it was bought. This can be done because that ‘fool’ expects to do the same to another person. Here, one can see the very essence of a bubble economy, irrationality. Investors are so embroiled by their greed and hazy understanding of this ‘new paradigm’ that they never stop to think about the asset that they’re dealing in and the actual value of that asset, beneath all that hype. Some do realize this, but most ignore this as the truth is too uncomfortable for them to face. Nevertheless, the trading continues at record-breaking prices and the asset’s value only gets higher and higher.

Profit-taking

Profit-taking is the stage at which the smart and rational investors leave the bubble. Now you may be confused. This whole time I’ve been saying that an economic bubble is the product of irrationality, how can smart investors ever be a part of it? Well, smart investors may not cause the inflation of a bubble, but they sure know how to make a fat profit. They see how most people regard this asset, hyping it up, and shooting its value up.

They see this while they themselves know that whatever that is being said about the asset is absolute nonsense, but they keep their silence and take part in this market frenzy. They buy cheap, or even buy expensive, but they sell it for a huge profit. They do this by following the greater fool theory. Once they see that there aren’t any ‘fools’ to sell to, they pull out and sell all their assets to realize absolutely massive profits. Estimating the time at which there no more ‘fools’ is a bit tricky. As economist John Maynard Keynes put it, "the markets can stay irrational longer than you can stay solvent."

Panic

This is the last stage of an economic bubble. Like all bubbles, an economic bubble must burst too. There are many causes to the bursting of a bubble, whether that’s the unprofitability of the asset or what it represents, or smart investors pulling out, causing others to follow suit which causes a dip in prices. Whatever it may be, there is no reversing a burst.

It is at the end of the panic stage that small and retail investors are left ruined and bankrupt. The assets that ascended so quickly in value also fell off just as quickly. Depending on the scale of the bubble economy, the effects of the burst can vary. If it’s like the 1980s real estate bubble of Japan, then the effects are felt, most the part, within the boundaries of the economic territory where the bubble arose. But, if the bubble is akin to the subprime mortgage crisis, then the effects can be felt worldwide.

Now even though most economists would agree that these are the 5 stages of an economic bubble, it is really difficult to assess whether or not we're in an economic bubble. This is due to the simple fact that it is really difficult to ascertain the intrinsic value of an asset, and that is a whole other story. But still, one can make economic judgments and can, to varying degrees, assess whether or not we're in an economic bubble or are going to be in one. Being able to make a judgment on this is absolutely necessary while investing as it can save you from a whole lot of financial worry. So use this knowledge carefully and correctly.