Hey there, Four Minute Finance readers. Congratulations on making it though the longest week in US history.
Because I couldn't spend another moment thinking about current events, today we’re going to chat about my favorite topic to nerd out over; Financial Bubbles.
We’ll take a look at how they happen, how to avoid getting caught in the hype, and how you might even benefit from them.
📰 In the Headlines
Breaking down this weeks biggest financial news stories
Translation: Meatless meat is figuring out its place in a post-pandemic world.
Yesterday, Beyond Meat’s stock went on a bit of a roller coaster ride. After a surge in sales at the beginning of the pandemic, their Q3 earnings report showed that excitement for this meat alternative was starting to wane, causing the stock price to sharply drop. However, an announcement in the afternoon about their collaboration with McDonald’s on the new McPlant Patties helped their stock jump back up.
Translation: Peloton doesn't think they'll slowing down anytime soon
Peloton announced that they are working with the Queen B herself on ‘creating a series of themed workout experiences ... across multiple fitness categories”. While they did not disclose the financial terms of this agreement, cinching Beyonce is not cheap, this deal shows Peleton believes that there are still plenty of new users and revenue for them, despite their extensive growth during the pandemic.
Translation: The race for food delivery domination is heating up.
Uber is now one step closer to being the dominant player in the food delivery industry. DoorDash is currently the leader in this market, fielding almost 50% of all app-based delivery orders in September. UberEats came in second place with 22 percent, and are now adding Postmates to narrow the margin even more. Uber has a reputation for doing whatever it takes to be the dominant company in any industry they are in. After taking years to secure their place as the leader of ride sharing, it looks like they are out to secure their place in expanding food delivery space as well.
🍾 About to Burst
People tend to get alarmed when the term “Bubble” is mentioned. Many of us lived through the dotcom boom of the early 2000’s, and even more of us watched the housing bubble burst in 2008-2009. After seeing the market collapse twice over and seeing the world suffer from the fallout, our fear around the topic is totally understandable.
With the rise of technology in investing and the constant news cycle, these price phenomenons are just becoming more common and anyone who is serious about investing in the stock market should take the time to understand them.
What is a Bubble?
Financial Bubbles, Economic Bubbles, Stock Bubbles, they go by many names. A “Bubble” is when the price of a stock or other investment keeps increasing past its actual value, based on inaccurate views of its actual worth.
They happen when investors think an asset’s price will continue to rise. People will pay a lot because they expect that they can sell for more. This keeps pushing up the price until reality kicks in and the bubble ‘bursts.’
By definition: It’s not a Bubble unless it bursts
It is actually really common for a stock price to suddenly increase and stay high, especially when there is a lot of hype around a company or a new product is unveiled. Financial journalists speculate about new bubbles occurring all the time, but the vast majority of ‘bursts’ they predict never happen.
The truth is, the story behind every bubble has been complicated and nuanced, which is why everyone feels blindsided when they pop.
The Cycle of Bubbles
It is almost impossible to spot a Bubble early on. When we do take a look back, they tend to go through four stages:
It all starts when people get excited about something new. For the dotcom boom, it was the rise of the internet in the early 2000's while for the the housing bubble, many experts point to the fall in interest rates in 2000–2003 as the trigger to the explosion in subprime lending.
At this stage, the market is usually small and prices low. Anyone who buys at this stage will profit the most, if they sell in time.
Once a price bubble starts to form, it becomes a self-perpetuating loop. As more people invest in the new thing, the price begins to rise.
Eventually, people who don’t have much relevant understanding start buying. They expect others to pay more for it in the future, so they don’t think they need to understand its value. The media loves to cover significant price increases and stories of early investors getting rich. As financial news tells their stories, more people invest and the price continues to inflate.
Economists call this irrational exuberance, when we think that because prices rose in the past, they will keep on rising forever.
We can only know something was a bubble in the first place after it bursts, but it happens the same way every time; Suddenly the price starts to rapidly drop, as everyone sells at the same time. We’re talking about a drop more significant than the usual day-to-day movement of the market. These corrections bring prices closer to the ‘correct’ level, where a bubble burst will bring the price far below it.
We don’t always know what causes a Bubble to pop, even after it happens. After the 1987 stock market crash Robert J. Shiller asked 1000 investors why they all sold at the same time. What he found was a chicken-and-egg situation: everyone sold because everyone else was selling. No news story or rumor was responsible, they only sold when the price started dropping. The same irrational exuberance that causes prices to inflate past their value happens again, just in reverse.
Bubbles In History
To understand how this all fits together, let's take a look at one of the most famous Bubbles in history: Dutch Tulip Mania.🌷
It may be hard to picture a boom and bust cycle around flowers, but the 17th century tulip mania is actually a perfect example of how investors can get swept up in a shiny new fad and forget all reason.
When tulips appeared in the Netherlands, everyone wanted one of these exotic looking flowers. The Dutch East India company was bringing in loads in new money into the Netherlands, and many people found themselves with disposable incomes for the first time in history.
Investors began buying tulip bulbs because they believed they could flip them for more money later. While the bulbs were initially only handled by those in the trade, middle-class and poor families began taking out credit or mortgaging their homes to buy bulbs they thought they could make a profit off. At the height of the tulip fever, bulbs were sold many times a day, and for thousands in today’s dollars.
At one point, people began doubting whether prices would hold up and began selling off their holdings. Panic ensued, leading to a massive price collapse, which spelled total financial ruin for many investors.
There are many fascinating stories that came out of Tulip Mania, and if you many to learn more, I highly recommend reading Mike Dash's book, Tulipomania.
The Boy Who Cried Bubble
Whenever a stock price increases a lot, you’ll hear numerous people calling it a bubble. It’s impossible to know if an asset is experiencing a bubble until after the crash. Many companies experience dramatic rises in their stock price, but never experience the crash everyone projects.
Financial media often speculate whether the prices of Zoom, TESLA, and Bitcoin are currently experiencing the effects of a bubble, or it their prices are justifiable. It's easy to find evidence to support either argument, because you could show two people the same information and they would interpret it in a way that supports their beliefs.
Investing always involved taking on risk, but there are a few ways you can try to avoid getting caught when a bubble busts.
How to Avoid The Bursts
- Question the Hype: If you weren’t able to tell by the events of last week, the news media will cover any story that keeps the audience watching. The media loves to cover big price increases and early investors getting rich, but they rarely go in to determine whether the value is actually there. Don’t assume that just because every news outlet is covering a stock, that it is actually a good investment.
- Understand the Value: In other words; do your homework. When the dotcom boom was at its height, investors overlooked basic rules of investing, such as looking at the companies’ business plans, revenues or price/earning ratios. You are always taking a risk when you invest, so be sure you understand exactly what you are putting your money into.
- Stick to Proven Concepts: As I mentioned before, bubbles most often occur around new products or technologies. If you prefer to stick with dependable investments with consistent returns, stick with investing in industries with long histories that are rarely in the headlines, they are less likely to experience the volatility of a bubble.
Final Thoughts: The Benefits of a Bubble
Although financial bubbles can be devastating for many, there are some long term benefits to this financial phenomenon.
Hyman Minsky is an economist who does a lot of research on economic bubbles, and he has found that major investment that happens during bubbles and up helping our economy long term. For example, the dot-com boom of the early 2000s arguably kickstarted the internet revolution by both introducing people to the idea and laying foundations for the technology we use now. Some of the most significant companies today started during that time.
A burst often leaves behind new infrastructure, technological developments, and other improvements. People learn from the mistakes of others and take advantage of what they left behind.
Let me know if you liked learning about Economic Bubbles, and if there are any other topics you like to learn more about!
Word of the Day
(n.) When a company buys most or all of the shares of another company to gain control of it.
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