Long overdue thought on how to spot a bubble in a market. Hopefully some economists with PhD have realized this and have published it somewhere with actual statistics.
You know a bubble is forming when: 1) Long-term financial/economic theories such as supply and demand are replaced by short-term greed. Or in other words, people ignore long-held financial maxims and react with greed instead of sound investment strategies. 2) This short-sightedness becomes acceptable to the general public or investing community.
Case examples:
1) Housing bubble of 2007ish: Here, a variety of factors led to this bubble and subsequent crash. First, lenders threw out sound loan practices (failure of part 1 above), and then many consumers jumped on board the ARM bandwagon (failure of part 2 above). Then you also had the advent of flipping. Certainly not a new concept, but many, many people took on this practice to make a quick buck. Of course, flipping is really just a huge pyramid scheme that inflates demand as people usually could not afford these second homes, and by pushing up the price and reducing supply while the home was being upgraded, this screwed-up the supply-demand curve. In many cases this was done by ignoring convectional wisdom that you do not buy a second home unless you can always afford the mortgage payment (failure of part 1). Failure of part 2, the widespread acceptance comes to us via TV shows such as Flipping Out and Flip that House.
2) Oil bubble that led to $4+ per gallon gasoline in 2008: Basically a fear driven bubble and a series of events that reduced production. Here, as we have all been told, if gas gets to $4 per gallon like it is in places like Japan and Western Europe, then demand will fall, as those countries generally use less gas per person than in the US. Again, simple supply and demand economics were ignored by investors looking to profit by the rising price of crude, as alternatives become more feasible as do more expensive production techniques/processes for harvesting more oil this will take hold and lower demand. We have always been told that expensive gas is the cure for US dependence on foreign oil. As to part 2, when T. Boone Pickens jumps on the bandwagon of oil going to be super expensive, then I think that qualifies as becoming acceptable to the investing community.
3) Dot.com Bubble of 2000: Greed drives stock prices through the roof, only to plummet once people figure out that companies spending $10 million a year but bringing in only $5 million will not actually last that long. Here, the main conventional wisdom was that you don't do IPOs for companies that don't make money, and you don't invest with companies that have not figured out how to even generate revenues to pay bills. Sure, a few companies like Amazon were able to grow big enough and eventually become profitable, but companies like HomeGrocer.com and many others never panned out. These companies had spent lavishly on IT equipment and computers and tech in general, which also created a bubble in those industries as the growth could simply not be sustained once everything fizzled out. To recap, part 1 comes from people looking for huge stock gains via purely growth instead of looking things like ROI or P/E. Part 2 comes from everyone and their mother jumping into the stock market to try and cash in on the next big thing.
So that's it. In essence, bubbles are really big pyramid schemes. You will do fine if you got in early enough, but get burned if you get in too late. And in the end, most everyone gets burned either directly or indirectly when the bubble bursts and recession ensues.
