1. #1

    Join Date
    Aug 2011
    Lahore, Pakistan
    Blog Entries

    Bubbles in the market

    It is very common to hear the word ‘Bubble” in context of financial markets. Bubbles often get created in the market and when they burst, financial market starts feeling the heat of it. Many times impact of financial market bubble also spills over to the real economy and causes a massive crisis across economy. The crisis that engulfed US financial markets in 2008 is an example of this. The effect of this crisis was felt across the world with stock markets tumbling across the world and the credit crunch followed it in an unthinkable proportion.

    So why do bubbles get created?
    What are key drivers that create and sustain bubble till the time realism checks in?

    The most important factor that drives bubble is greed and desire to generate high level of returns. Look at the current scenario in Pakistan. There have been very nominal changes in macro-economic factors. Some macro-economic factors have become better like inflation driven by fall in commodity prices, while some have worsened like balance of trade, GDP etc. Overall, there is no significant change in the economy that needs to be cheered. However, the stock market and the debt market both have shown significant positive changes. In fact it won’t be an exaggeration to say that stock market has gone up as if there would be no tomorrow.

    The fact that stock exchanges have gone up substantially can only be described by the unparalleled liquidity that the global markets is experiencing right now. Since there has been no real change in the macro-economic parameter this is a fit case of bubble. However, it does not mean that the bubble will burst soon. If economic scenario improves in future, bubble may sustain and gain momentum but if economic scenario worsens, there may be a sudden fall in the market. The creation of bubble is often driven by greed and quick returns as mentioned earlier and the market players, especially traders leave no opportunity to en-cash it.

    Another factor that drives bubble is the over confidence that starts building in the market once things turn positive. This over confidence often gets converted into irrational exuberance. When bulls take over the market, bear become rare species. There comes a stage where the idea of market going down from unprecedented high levels is scoffed at and critics of bull market are slammed. But the reality checks despite of these factors and market ultimately fall down.

    Regulatory nonchalance also becomes a reason for creation of bubble. It is generally believed that the market forces decide price of shares and bonds and hence interference at any stage is against the basic premise of equilibrium that the market creates on its own. But this idea also gets shattered once bubble burst. No wonder maximum regulatory changes are brought after the financial crisis. US has seen it twice at a very large scale

    1) post great recession and

    2) After 2008 crisis.

    Last but not the least, will the formation of bubble stop. The answer is a firm no. The reason is very simple. Adam Smith once said that man by nature is guided by principles of self-interest. This self-interest is nothing but greed that reflects itself in many forms. Anybody betting on greed ceasing to exit is sure to lose his money. So bubbles will be formed and will continue to burst.

    The question is will you be able to benefit from bubble. Even if you do, don’t get fooled by randomness.

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