Market Cycles and Bubbles
Bull and bear markets, corrections and crashes, and the recurring patterns of great speculative bubbles – from tulip mania to the dot-com boom.
Key takeaways
- A bull market is a long rising phase; a bear market is a fall of at least 20% from the peak.
- Historically, bull markets have lasted much longer than bear markets and gained far more than bear markets destroyed.
- Bubbles follow recurring patterns – a credible new story, cheap money, rising prices that pull in ever more buyers, and finally the certainty that “this time is different”.
- Identifying a bubble is hard; predicting when it bursts is nearly impossible.
- Trying to dodge crashes often means missing the best days – which tend to occur in the middle of the worst periods.
Markets don’t move in straight lines. Long advances are followed by setbacks, euphoria by disillusionment. Sometimes euphoria escalates into a speculative bubble whose collapse shakes entire economies. Knowing the patterns makes it harder to get swept along by the mood – in either direction.
The language of market phases
| Term | Definition (common convention) |
|---|---|
| Pullback | Decline of less than 10% from the high |
| Correction | Decline of 10–20% from the high |
| Bear market | Decline of at least 20% from the high |
| Crash | A very fast, violent fall, often within days |
| Bull market | A sustained rise, usually measured from a low at least 20% below |
The animal names are said to come from how the animals attack: the bull thrusts its horns upward, the bear swipes its paws down.
What history shows
Corrections of 10% are normal and have historically occurred in the S&P 500 roughly once every one to two years on average. Bear markets are rarer but have come along on average every five to seven years.
The key is the asymmetry: bull markets have lasted several years on average, bear markets typically around a year. And gains in the up phases were far larger than losses in the down phases. That’s why broad stock markets have risen over the long run – despite every crisis.
How bubbles form
A speculative bubble exists when prices rise far beyond what earnings or sensible expectations justify – mainly because buyers are betting on still higher prices. Economist Hyman Minsky and historian Charles Kindleberger described the typical stages:
- Displacement: a genuine innovation – a technology, a new market, a policy shift – opens up credible profit opportunities.
- Boom: cheap money and early successes attract capital. Rising prices confirm the story.
- Euphoria: more and more inexperienced buyers pile in, often with borrowed money. Old valuation yardsticks are dismissed. Sceptics are mocked.
- Peak: insiders and seasoned investors start selling. Prices stall.
- Panic: a trigger – a bankruptcy, rising rates, a fraud – flips the mood. Those who bought on credit are forced to sell.
- Revulsion: prices often fall well below fair value.
Famous bubbles
Can you spot a bubble?
In hindsight, every bubble looks obvious. In real time it’s much harder. Warning signs include:
- valuations far above historical norms, justified with “this time is different”,
- rapidly rising borrowing to buy assets,
- a rush of inexperienced investors and stories of quick riches among friends,
- a flood of IPOs and products cashing in on the theme.
But markets can stay irrational far longer than seems possible. Then-Fed chair Alan Greenspan warned of “irrational exuberance” in December 1996 – the Nasdaq then rose for more than three more years, to more than three times its level.
Why market timing is so hard
The obvious idea: get out before the crash, get back in afterwards. The problem: you have to be right twice. And the best days in the market tend to fall in the middle of the worst periods – often just days after the biggest losses.
Summary
Markets move in cycles of advance and retreat. Corrections are normal, bear markets come regularly, but up phases have historically lasted longer and gained more. Bubbles follow recurring patterns that look obvious in hindsight and are hard to see in real time. For most investors, building a portfolio they can hold through every phase is wiser than trying to call the turning points.
Time to practise
11 short exercises on this lesson – mistakes come back at the end. Then the lesson is complete and joins your review queue.
Test your knowledge
0/301An index falls 14% from its high. What’s that called?
02What’s typical of the late stage of a speculative bubble?
03Why is it so hard to avoid crashes by getting out and back in?