A bubble is when an market, asset or economy has a huge price spike, exceeding what is believed to be its fundamental price by a huge margin. Bubbles are typically identified in hindsight, generally after there has been a crash of the cost of the economy, market or asset in query.
The damage caused by the burst of the bubble depends on the business sector or sectors concerned: the bursting of the US housing bubble in 2008 caused a global financial crisis, because most banks and fiscal establishments in America and Europe held many billions of dollars worth of subprime mortgage-backed securities.
The 5 steps of a bubble
Economic guru Hyman P Minsky identified 5 stages in a credit cycle: displacement, boom, euphoria, profit taking and panic and this general pattern is fairly consistent across bubbles in varied sectors.
Stage 1 Displacement
Displacement happens when investors become bewitched with something new: new technology in the dot-com bubble, tulips in tulip mania (a bubble in the 17th century where the acclamation for tulips rose so speedily that tulips started selling for over 10 times the once a year income of skilled artists. Within months of the bubble bursting, tulips were selling for 1 / 100th of their peak costs), or historically low interest rates, as in the US in June 2003, which started the build-up to the housing bubble.
Stage 2 Boom
Following a displacement, costs start rising slowly. They gain momentum as more participants enter the market, causing the asset to attract widespread media coverage, then panic buying, which forces costs to new highs.
Stage 3 Euphoria
Costs skyrocket: in the 1989 real estate bubble in Japan, land in Tokyo sold at least USD139,000 per square foot. At the height of the internet bubble in March 2k, the combined price of the tech stocks on the NASDAQ was larger than the GDP of most countries.
During the euphoric phase, new valuation measures are promoted to explain the jump in costs.
Stage 4 Profit taking
By this time, skilled traders start selling their positions and taking profits sensing that the bubble is going to burst. However, deciding the moment of collapse can be very difficult and, if you miss it, you have likely missed your chance to take profits for good.
Stage 5 Panic
At about that point, costs fall as quickly as they originally rose. Traders faced with margin calls and the falling values of their assets start panic selling: getting out of their investments at any cost. Supply shortly overwhelms demand, and costs plummet.
In the 1989 Japanese property bubble, property lost almost 80% of its inflated value while stock prices declined by 70%. In a similar way, in October 2008, following the breakdown of Lehman Brothers, and the almost-collapse of Fannie Mae, Freddie Mac and AIG, the SP 500 dropped nearly 17% in that month. That month, global equity markets lost USD9.3 trillion, or 22% for their combined market capitalization.
Being acquainted with the steps of a bubble, if it's in the stock, forex , commodities or bonds market, may aid you in identifying the next one, and get out before your profits disappear.