People taking an irrational financial decision or herb mentality is not something new. Heart attack and market crashes happen when it is expected the least. Stalwarts fail to find irrational human behavior in the stock market. Behavioral finance is a field of finance that proposes psychology-based theories to explain stock market anomalies such as severe rises or falls in stock price.
An old saying goes likes this Prevention is better than Cure. Being prepared for the bubble is better than recovering later.
Nevertheless, fundamentally to this stage could be a start of the bubble. Valuations are supporting the fact. Price to Earning are is not contrasting with an increase in earnings. Historically we have seen when the PE ratio of the index goes above 24 returns are negative 14% for next three years.
A very basic understanding of stock market bubble is best explained by Wikipedia
A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation.
A stock market bubble does not necessarily have to start with the stock market. For instance, the market crash of 2008-09 was because of asset bubble from the subprime crisis. In the era of high interconnectedness, we are not immune to risks outside our country. People may argue that we are growing at 7% annually which most developed nations are finding tough to achieve. Internal growth values and development does not make one country immune to outside risks.
Now coming to the new age caveats. Cryptocurrency is the talk of the town. Haven’t you heard it? There are people investing billions of dollars in these currencies which started with one currency bitcoin and now there are thousands. The total market capitalization of currency is USD: $114,100,645,670. as on 15th June 2017 while writing the article.
Now, this brings me to our next heading which is an asset bubble.
Definition which I found in Financial Times
When the prices of securities or other assets rise so sharply and at such a sustained rate that they exceed valuations justified by fundamentals, making a sudden collapse likely - at which point the bubble "bursts"
The science of asset bubble is still a topic of research to many. When the recent highs become the new normal then people stop looking at fundamentals and start believing that something higher is waiting for them. Or people know that they are buying at the price which is very high but only with the confidence that they will find another fool to buy at the even higher price. Price rise very fast in a very short time and there is not much change fundamentally in the asset. Another theory suggests that people who get caught in number are highest at the top. The guilt of losing an opportunity and paying the high price of the new normal thinking something great is waiting.
Its is alarming at the way a currency is behaving. You can find the market cap of the cryptocurrency at the website https://coinmarketcap.com
Prices of the currency have been on a continuous run. At these level, the currency has become very sensitive. Even the smallest of a problem can spiral out of control before they realize what is happening.
Let see what people have to say about this new asset.
— Prof. Steve Hanke (@steve_hanke) June 12, 2017
Now talking about behavioral science in the financial market this tweet has explained it aptly about how people behave in the financial markets.
Crypto-currency trading these days. pic.twitter.com/vPGno0NEI4
— Paul Buitink (@paulbuitink) June 12, 2017
What if the bitcoin bubble bursts? https://t.co/J6OWqAAet4
— The Economist (@TheEconomist) June 13, 2017
Finally the dot-com bubble and today’s comparison chart for better understanding.
— Jonas Haberkorn (@JonasHaberkorn) June 10, 2017
The motive behind this article is to be cautious.
Only when the tide goes out do you discover who’s been swimming naked.
– Warren Buffett
True to the subject prevention is better than the cure. It is just a caveat emptor.
In nutshell, the cryptocurrency is booming, what is really missing is regulation. Fundamentally things have to change for a larger good. A market bubble is a good sign in those terms.
This is my perspective. Being cautious is our duty.
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