Bull market, bear market, crash, bubble
Four terms that get thrown around constantly and rarely get explained. Above all: declines aren't the exception, they're a regular part of how markets work.
A bull market is an extended period of rising prices; a bear market is an extended period of falling prices. A bear market is usually defined as a drop of at least twenty percent from the last high.
A crash is a very fast collapse within days. A bubble is something else: a period where prices have drifted far from any reasonable basis, because everyone's buying, because everyone's buying.
What matters for you is frequency. Ten-percent declines happen about once a year on average; twenty-percent declines happen every few years. If you invest, you won't maybe experience this, you will experience it.
Bubbles are only reliably identified in hindsight. But recurring signs exist: new explanations for why this time is different, people with no prior knowledge suddenly all jumping in, and debt used as the stake. If your hairdresser is giving you investment tips, that's a data point.
The twenty-percent threshold for a bear market is a convention with no theoretical basis, useful as shared vocabulary, not as a signal. Distribution data is more informative: declines are a regular feature of stock markets, and their frequency falls with depth, roughly following a power-law shape with far heavier tails than a normal distribution would suggest.
For bubbles, Hyman Minsky's model offers a useful framework, with phases of displacement, boom, euphoria, profit-taking, and panic. The central mechanism is rising debt financing: as long as positions are leveraged, a price drop forces sales, which trigger further drops. The collapse isn't a shift in sentiment, it's a mechanical consequence of the financing structure.
Distinguishing a bubble from a justified repricing in real time remains empirically difficult. High valuations can be justified by low interest rates or genuine future growth. More reliable than valuation levels alone are indicators of financing structure, such as the volume of leveraged positions relative to market capitalization.
Summary
- Ten-percent declines happen almost every year; twenty-percent declines happen regularly.
- Bubbles burst mechanically, because leveraged positions force sales.
- In real time, a bubble is hard to identify with any confidence.
Did you get it?
At what decline is a bear market usually said to begin?
Roughly twenty percent from the last high. That's a convention, not a signal.
What mechanism causes bubbles to burst?
Leveraged positions force sales as prices fall, which triggers further declines.
How is a bubble best identified in real time?
Less by high valuations than by the extent of debt financing in the market.
Related
- The 1929 crashMarket History
- Compound interestStage 0
- LiquidationStage 2