Extreme Greed & Fear Creates Boom & Busts

We have all heard the phrase “Boom and Bust”, but what is it? What causes it? More importantly what effect can it have on our investments?

What is Boom and Bust?

“Boom and Bust” describes the sequence where an economy, commodity or market sector goes from surging forward, making lots of profit and growing at breakneck rates and is generally along the way improving the wealth and standard of living of all participants in the market.  A boom is usually accompanied by a significant amount of greed or irrationality about the underlying fundamentals of the Boom.

“Bust” refers to the contraction of the previous boom, usually fueled by a significant economic or fundamental change in the criteria that fueled the boom in the first place.  This tends to result in various side effects ranging from a reduction in profits, earnings, growth, increased unemployment, restriction of credit, and of course, a strong change of psychology of the market participants from optimism and greed to pessimism and fear.

Why do “Booms and Busts” occur?

Take for example the famous Dotcom boom of 2000.  Greed surged into the marketplace on the misplaced belief that new Internet-based technology would fundamentally shift the market dynamics 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  Technology became fashionable and “Bricks and Mortar” businesses were perceived to be outdated and almost worthless.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 that money poured out of “Bricks and Mortar” stocks at an equal rate.

Signs of A Bust

A telltale 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 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 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 Price Earnings (PE 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.

The Year 2000 Dotcom Bust

In the year 2000, the PE 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 huge profit expectations would not be met by the tech. industry, the entire sector collapsed, bringing with it other industries, indices, and markets.  The technology bubble had burst.

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