THE LIFE CYCLE OF A BUBBLE
1. A genuine advancement creates real productivity gains. A real technological or economic improvement increases productivity and leads to genuine revenue and earnings growth.
2. Stock prices leak into reported profitability. Rising stock prices improve reported earnings, financing conditions, collateral values, and perceived business performance.
3. Reported profitability drives real investment. Companies increase hiring, capital spending, construction, expansion, and speculative investment because of their own or their customers’ reported profitability.
4. Bubble beliefs and abandonment of present-value discipline. Investors stop focusing on discounted cash flows and begin relying on continuing gains from the greater fool theory, believing they can sell later at a higher price.
5. Inflows from sideline investors. Previously cautious investors enter the market in large numbers. New money from existing and new investors participation drive prices higher.
6. Extreme overvaluation. Prices rise far above historical normal multiples of reported fundamentals, even ignoring the fact that reported fundamentals have been driven by rising stock prices.
7. Issuance. Companies take advantage of high valuations through IPOs, secondary offerings, stock-based acquisitions, SPACs, and insider selling.
8. Exhaustion of inflows. The flow of new investors starts shrinking while existing investors approach their risk and leverage limits. Volatility and dispersion grow and gains become less uniform across stocks.
9. Earnings disappointments from slowing price appreciation. As stock prices stop rising rapidly, the earlier boost from higher valuations into earnings weakens or reverses. Companies begin missing expectations.
10. Stock-price collapse with high volatility. Confidence in both the fundamental growth and in the greater fool theory break down and prices fall sharply. Volatility rises further as leverage unwinds.
11. Bear-market rallies and progressively greater exhaustion. Bargain hunters and frustrated latecomers repeatedly buy the dips, creating violent temporary rallies that fail. Markets make lower highs and lower lows.
12. Capitulation, abandonment, and normalization. Bubble participants eventually give up in disgust or exhaustion. Volatility falls, valuations normalize, and the market returns to more ordinary behavior.
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