Bull market, bear market, crash, bubble
You hear bull market, bear market, crash and bubble all the time, but they're rarely explained. The most important thing first: declines aren't the exception. They belong to the market like rain belongs to the weather.
Learning objective: After this lesson you can tell bull, bear, crash and bubble apart correctly and put them in context.
A bull market is a longer period of rising prices, a bear market a longer period of falling prices. People usually speak of a bear market once prices are at least twenty percent below their last high.
Crash and Bubble
A crash is a very fast fall within a few days. A bubble is something else. Prices have moved far away from anything reasonable, mainly because everyone is buying because everyone is buying.
How Often Declines Occur
What matters most for you is how often this happens. Declines of ten percent come about once a year on average, declines of twenty percent every few years. If you invest, you'll definitely go through them.
Signs of a Bubble
Bubbles can usually only be identified afterwards. But some signs keep coming back. Everyone explains why this time is different. People with no experience at all suddenly pile in. And many buy with borrowed money. If your hairdresser gives you stock tips, that's at least a hint.
The twenty percent line for a bear market is a convention. There's no deeper reason for it. It's useful so everyone means the same thing, but it's no signal to act. What tells you more is how often declines of each size happen. Small ones are common, big ones rarer. But very large crashes happen far more often than a normal distribution would suggest. Experts speak of fat tails.
The Five Phases of a Bubble
For bubbles, the economist Charles Kindleberger, building on Hyman Minsky, described a model with five phases: a trigger, the boom, euphoria, first profit taking and then panic. The core is borrowed money. As long as many have bought on credit, every price drop forces some of them to sell, and those sales push prices down further. The collapse is then less a matter of mood than an almost mechanical result of how the purchases were financed.
Bubble or Justified Price
In the middle of it, it's hard to say whether a bubble is forming or whether high prices are justified. Low interest rates or genuine future growth can justify high valuations. Looking at debt is more reliable than valuation alone. A warning sign is when the share of purchases on credit rises sharply relative to the total market value.
Data as text
Drops of 10 percent happen about every year, drops of 20 percent every few years, and drops of 40 percent a handful of times per century.
Summary
- Declines of ten percent happen almost every year, of twenty percent regularly.
- Bubbles burst because purchases on credit trigger forced sales when prices fall.
- In the middle of it, a bubble can hardly be identified for sure.
Did you get it?
From what decline do people usually speak of a bear market?
From about twenty percent below the last high. That's a convention, not a signal.
Why do bubbles burst?
People who bought on credit have to sell when prices fall, and those sales push prices down further.
How can you best spot a bubble while it's happening?
Less by high valuations than by how much is being bought with borrowed money.
Check your understanding
Your task
Your portfolio is worth $20,000. Calculate at which value a decline of 10 percent and at which value a decline of 20 percent is reached, and write one sentence for each on what you would do. Test in the crash test whether you stick to that answer.
Sources and further reading
- First Trust publishes a public overview of how often and how long US bear markets (declines of at least 20 percent) have historically lasted since 1942. View source ↗
Related
- Compound interestStage 1
- Risk and return are linkedStage 1
- The 1929 crashMarket History
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