Probably the biggest fundamental truth to any market is that markets rarely remain in perfect equilibrium Instead, markets (such as the real estate market from 1998 through 2009 or the stock market from 1996 through 2003) move through different stages of asset price levels, participant psyche, and fundamental value.

The following are what I observe to be the 6 changing stages of any market.

Stage #1: Pricing Supported by Fundamentals

  • Asset prices are in-line with historic norms.

Stage #2: Speculation Starts

  • Market participants identify the current trend and project that it will continue indefinitely — speculation starts.

Stage #3: “New” Pricing Justified

  • Asset prices are so distant from historic norms that they are justified by new economic theories.
  • For example, during the 1990’s tech bubble, higher price-earning ratios were justified and main stream media proclaimed that we were in a “new economy”.

Stage #4: Mania

  • When more and more buyers / speculators want to get in on the action, asset prices go through the roof.
  • Consequently, even “junk” sells as easily as quality assets as unsophisticated buyers are taken advantage of by deal promoters in sometimes fraudulent schemes.
  • Transaction volume and pricing reach levels that cannot be explained rationally.
  • For example, during the tech bubble many internet companies with no real revenue and/or profit went public with ridiculously high valuation (and failed quickly).  During the 2006 peak of the real estate market, “liar loans” and “flipping” were rampant.

Stage #5: Crash and Burn

  • There are few new buyers and no more “greater fools” so buying demand drops and asset prices fall rapidly and dramatically.

Stage #6: Never Again

  • Lessons are learned and new regulations are proposed or implemented to curb the abuses that “caused” the market crash.
  • Assset prices may be below long term economic value of the underlying asset.

However…

Despite many visible and memorable booms and busts, the odds are that we will NOT remember that market cycles exist; instead, most market participants will get caught up and participate in the next bubble.

“There is NO doubt that sometime in the future, we are going to have this conversation again.  It will not be for quite a period of time, but it will occur because the flaws in human nature are such that we can not change that.  It doesn’t work.”

– Alan Greenspan speaking in reference to the simultaneous collapse in the credit, stock and real estate markets in 2008.

Start over at Stage #1 and repeat the cycle.

What do you think?

Do you agree with the 6 stages I’ve identified?  What stage do you think we are in the real estate, stock or other markets you know of?  What are some market cycles you have observed in your lifetime?

Please comment and share your opinion.

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