Riding The Market Bubble:- Don't Try This At Home

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Brian Perry

12 Aug, 2016

in Money Management

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.

Crisis in the Making
The combination of price appreciation and an increase in new entrants to the market are defining characteristics of market bubbles. Investors should remember that many bubbles are based on attractive fundamentals, which explain why money flows into the market in the first place. 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

Common Factors
In addition to the emotions of greed and fear, a review of the historical record shows that several common factors have been present at the onset of many financial crises. These factors include:

  1. asset/liability mismatch
  2. excessive leverage
  3. excessive risk
  4. currency mismatches

Frequently, more than one of the factors are present, and each of the factors can be heightened by another.

1) Asset/Liability Mismatch
An asset/liability mismatch occurs when there is a wide differential margin between the duration of a financial institution's loans and investments and its deposits or other funding sources. This factor was present in the 2007 collapse of Bear Stearns and the 2008 Lehman Brothers bankruptcy. 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.

2) Excessive Leverage
Asset/liability mismatches are present to some degree in many financial institutions. In fact, one of the main purposes of financial intermediaries is to facilitate the transformation of short-term deposits into long-term loans. Under normal circumstances, this mismatch is manageable. 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 (LTCM) collapse in 1998.

3) Excessive Risk
Another common cause of financial crises is that financial institutions take on excessive risk. This may occur intentionally, like when savings and loan institutions (S&L) invested in risky real estate deals in the 1980s, eventually prompting the S&L crisis. Excessive risk can also occur unintentionally; investment banks and other financial institutions that purchased mortgage-backed securities prior to the 2008 credit crisis believed they were safe.

In another famous example, Long-Term Capital Management (LTCM) 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.

4) Currency Mismatch
Governments sometimes find themselves in trouble when their borrowing is denominated in a foreign currency. This is a common factor in emerging market debt crises, including the Latin American debt crisis of the 1980s, the Asian financial crisis of 1997 and the Argentinian debt default of 2002. 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
Financial crises do not always have a severe economic impact. The U.S. stock market crash in October, 1987 was the worst in U.S. history to date, but the market soon recovered and there was minimal economic impact.

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% in Indonesia, 7.3% in Malaysia and 10.5% 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
The key to minimizing the effects of a financial crisis seems to rest upon two principles, as explained in the book "Lombard Street by Walter Bagehot – 2005”

  • 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 U.S. this guarantee comes in the form of the FDIC insurance program.

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I have learned only this about trading through bubbles (from the 1999-2000 tech bubble) -
When prices are rising you should be long: but not when they're not.

An easy rule to compose, full of truth. Sadly, it took me another 3 lean years to absorb the implications.

Aug 12, 2016

Member (6318 posts)

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