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The Inverse Bubble?

Written by Andrew Kerr Thursday, 03 September 2009 02:33

(0 votes, average 0 out of 5)

About a year ago, while the markets were crashing, I had the idea that an 'inverse bubble' may be forming (at the time of course I thought it was a brilliant, innovative idea). After a quick google search, I saw that John Kay had already written an article about the inverse bubble for the Financial Times. I once again felt the Nobel prize for economics slipping through my fingers.  But, after seeing the slow and weak recovery of the markets over the past six months, I am starting to question whether an inverse bubble could actually exist.

For those unfamiliar with the terminology, according to Wikipedia, a stock market bubble occurs when "market participants drive stock prices above their value in relation to some system of stock valuation". The bubble inevitably bursts when it becomes too full and the result is a rapid decline in stock prices.

An inverse bubble would therefore occur when market participants drive stock prices significantly below their value in relation to a stock valuation system. However, history has shown that after a significant drop, prices tend to rise more slowly than they fell. The chart below shows the S&P500 since the 1950s

Source: Yahoo! Finance

There can be any number of explanations for this, here are some that I have come up with

  • The 'once bitten, twice shy' approach - Investors who lost money in the markets during the collapse shy away from immediately pouring their money back into the market, gaining confidence over time.
  • It is far easier to sell a stock that you own (thus inflating the inverse bubble) than it is to buy a stock if you don't have any money to do so. For a recovery to take place, there must be buyers in the market. Buyers can only purchase shares when they have the cash to do so. When a stock sell-off occurs, wealth is wiped off the market and it takes time for buyers to rebuild their wealth.
  • Investors that still have capital in other assets, spotting the bottom of the bubble shift their assets towards equities in order to take advantage of a potential rise in the market. However, this shift is not enough to offset the massive decline in prices.
  • Investor psychology plays a significant role in bursting a regular bubble as individual events can cause a bubble to burst, but it is hard to point to individual events that would warrant a similar increase in share prices. If it doesn't burst then it's not a bubble

 

Feel free to leave comments regarding this issue.

 

 

 


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