102-06 Booms and Busts

Boom & Bust

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 stock market on the misplaced belief that new internet-based technology would fundamentally shift the future market dynamics and business models. Technology became fashionable, and “Bricks and Mortar” businesses were perceived as outdated and almost worthless. This paradigm shift meant that money poured into technology stocks at an unrepentant rate, and capital flowed out of “Bricks and Mortar” shares at an equal rate.

A telltale sign of problems to come was noticeable when stock analysts would suggest Price Earnings valuations on tech stocks of 200, 300, or more were reasonable even though the 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, it will 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 company’s earnings capacity.

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 utterly unrealistic. By the time the inevitable correction was completed, the P/E Ratio for the S&P500 had halved to just over 20. Professional analysts and so-called market gurus fueled much of the greed and hype. They became greedy and euphoric, a heady mixture.   When everyone slowly began to realize that the tech industry would not meet the enormous profit expectations, the entire sector collapsed, bringing with it other industries, indexes & markets. The Tech Bubble had burst.

What is the PE Ratio? How to Use the Formula Properly.

102-06 Booms and Busts - 1

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, mutual funds, and stock portfolios; we lost jobs, earning power, and risk appetite.

It seems that the time interval between the 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 be one of the best times to buy.


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