The 5 Stages of a Bubble

There’s a lot of talk in the media today about bubbles. Certainly anyone who has been watching stock markets for the past several years has at least an inkling that stock markets may be in a bubble. But diagnosing a bubble isn’t just a question of following a hunch. To really analyze a bubble requires knowledge of bubbles and their stages.

The stages of a bubble really only become crystal clear in hindsight to most people. But those who can sense a bubble and its stages, anticipate the next steps, and adjust their investments accordingly stand a good chance of protecting themselves from the negative effects of a bursting bubble. Familiarize yourself with the five stages of a bubble and you too might be able to protect yourself when the next bubble bursts.

1. Displacement

The first stage of a bubble is known as displacement. That means that something happens in markets to upset the norm, and investors start to get carried away with new developments in a particular asset class or sector of the market. We saw this in the late 1990s when the development of the internet fueled interest in technology companies, leading to the dotcom bubble. Many companies promised results they just couldn’t deliver, and many of them went belly up when the dotcom bubble burst.

The mid-2000s saw the popularity of mortgage-backed securities, in which mortgages were packaged together, cut up into tranches, and marketed to investors. It seemed like financial magic that subprime mortgages could be packaged together into AAA-rated securities, giving high yields with little risk. As we found out in 2008, however, it wasn’t magic, just Wall Street chicanery. Stock markets lost over 50% of their value, and many investors lost years, if not decades, worth of investment gains.

Now we’re in a second tech bubble, with Big Tech stocks such as Apple, Facebook, Google, Netflix, and Tesla fueling much of the recent growth in stock markets over the past several years. Many analysts and investors think of these companies as the wave of the future, and think there is no way they could go under. But history has a way of repeating itself, and the new paradigm of investing in tech stocks to get rich could very well end the same way the dotcom bubble did.

2. Boom

Once the displacement phase ends, the boom phase begins. The current stock market boom started in 2016, after stocks reached a low point in February of that year. Growth was slow at first, but really began to take off after Donald Trump was elected President. From around 18,300 points on election day in 2016, the Dow Jones Industrial Average rose to a record over 20,000 points five days after Trump’s inauguration. 21,000 came just over a month later, and by January 25, 2018, a year after the Dow first closed over 20,000 points, the Dow closed at 26,392 points.

There have been a few bumps in the road since then, but the Dow Jones currently sits at around 31,000 points, nearly double what it was five years ago. That’s pretty significant growth, even if it pales in comparison to other 5-year periods during bull markets. It’s pretty clear that stock markets are in a boom phase, but have we reached the next stage?

3. Euphoria

Euphoria is the phase at which investors begin to forget about fundamentals. They think “this time is different” as they plow ever more money into the market. But this time is never different. It’s always the same old story, that those who rush into markets late in the boom phase end up holding the bag when markets inevitably tank.

At the euphoria stage, investors begin to think that prices will continue rising forever, and that there will always be a buyer available when they’re ready to sell. But by the late stage of euphoria, most of those who were going to get into the market have already gotten in, and those late to the party will eventually find that there aren’t any other fools willing to jump in and pay exorbitantly high prices for overvalued stocks.

We’re seeing some definite signs of the euphoria stage right now, in a number of different areas. The example of Gamestop could be one, in which investors are disregarding the poor fundamentals of the company and jumping into the stock to teach hedge funds a lesson. They’re planning to hold the stock for a long time and, while the instigators of the incident don’t care if they lose money, many more actually think that Gamestop shares will continue to rise and that they’ll be able to cash out at a profit in the future.

4. Profit-Taking

Profit-taking begins when market actors begin to get worried about stock valuations. The first profit-taking can begin months or even years before a panic sets in, as investors with lower risk appetites begin to get worried about losing money or the inability to properly value their investments.

Very often, the first people to get out of markets are derided by those who stay in. Some may even begin to second-guess their decisions, particularly if markets continue to climb. And some may even succumb to the temptation to jump back in, hoping to wring out every single penny from the bull market before it collapses.

We may very well be passing from the euphoria stage to the profit-taking stage right now. There’s no telling how many people have already cashed out, locking in the gains they’ve made in stock markets over the past few years. Some of those investors have decided to invest in precious metals like gold and silver to protect their wealth.

Many other investors are likely looking at markets worriedly, wondering when the crash will come, and what will precipitate it. Crashes, like bubbles, very often are diagnosed in hindsight. We’ve already seen a handful of false alarms over the years, with the 35% drop in early 2020 being particularly dramatic. But while everyone seems to understand that the next “real” crash could make 2008 look like peanuts, no one knows when it will happen. And the longer that crash is put off, the more complacent many investors may become.

5. Panic

When panics really get going, investors get nervous. Values begin to drive downward, and fearful investors rush for the exits, looking to sell their assets for anything they can get. Panics often start small, with a little pin prick that pops the bubble. But once the bubble starts deflating, it can deflate rapidly.

This is the make it or break it moment for investors. You have to decide whether you want to cash out, or whether you want to ride the panic down to the bottom and continue through the recovery. In many cases, that decision is determined by your investing time horizon.

If you have 20-30 years before you’ll need to touch your retirement assets, you may be able to afford to wait for a recovery. If, however, you’ll need to take distributions from your retirement accounts within the next 5-10 years, you may not have enough time to recoup your losses before you need to tap into your retirement savings, and you may end up locking in losses.

Can You Protect Yourself Against a Bubble?

Of course, the best way to protect yourself against a bubble is not to allow yourself to be subjected to it in the first place. If you protect your retirement savings before the bubble bursts and the panic sets in, you can save yourself much of the heartache that otherwise might beset you when markets tumble.

Thousands of investors have already protected their retirement savings with gold and silver. With a gold IRA or silver IRA you can even roll over or transfer retirement assets from your existing accounts such as a 401(k), IRA, TSP, or similar account into your precious metals IRA. That gives you the ability to invest in physical gold or silver coins and bars, while still offering you the same tax advantages of your existing retirement accounts. Better still, those transfers and rollovers can be done without any tax consequences.

If you’re worried about an upcoming panic, you owe it to yourself to protect your assets against the effects of that panic, ideally before the panic starts. Call the experts at Goldco today to learn more about how gold and silver can protect you and your investments when bubbles inevitably burst.