This is an excerpt from the Liberated Stock Trader Book and Training Course.
Why do Booms and Busts occur?
Take for example the famous DOTCOM boom of 2000. Greed surged into the market place on the misplaced belief that new internet based technology would fundamentally shift the market dynamic and business models of the future. Technology became fashionable and “Bricks and Mortar” businesses were perceived to be outdated and almost worthless. This paradigm shift meant that money poured into technology stocks at an unrepentant rate and money poured out of “Bricks and Mortar” stocks at an equal rate.
A tell tale sign of problems to come was really noticeable when stock analysts would suggest Price Earnings valuations on tech stocks of 200, 300 or more were reasonable even though he companies in question had never made a profit. The Price Earnings Ratio is the ratio of the Stock Price to its actual earnings. If a P/E Ratio is at 30 then it would take the company 30 years to earn back the share price. The higher the P/E ratio the higher the expectation that the stock will perform well in the future. You can also see the P/E ratio as a valuation of the worth of the stock, if the P/E is 200 you are essentially paying 200 times the earnings capacity of the company.
In the Year 2000 the P/E Ratio of the S&P500 reached nearly 45. This was an all time high and essentially indicated that the expectation of the market participants was completely unrealistic. By the time the inevitable correction completed the P/E Ratio for the S&P500 had halved to just over 20. Much of the greed and hype was fueled by professional analysts and so called market gurus. They became greedy and euphoric, a heady mixture. When everyone slowly began to realize that the the huge profit expectations would not be met by the tech industry, the entire sector collapsed bringing with it other other industries, indexes & markets. The Tech Bubble had burst.
How does this affect our investments?
The boom is good for our investments in the short term but only if we move into cash before the bust, which of course only the enlightened few ever manage to achieve.
So who suffers the wrath of the Bust? The private investor, you and I! We lost money in our pensions, our mutual funds, and our stock portfolios; we lost jobs, earning power and our appetite for risk.
It seems that the time interval between economic crisis and the boom bust sequence is happening at shortening time intervals, so it always pays to beware. When every analyst is screaming “Buy Buy Buy” and acting like the best thing in the world is happening, that is the time to be most careful. When all the market reports are reiterating what a depressing time it is, how there is no future in the stock market and when prices have lost 20% or even 50% of their value, that could possibly be one of the best times to buy.
Other Chapters of the book are here