Financial Crashes and Bubbles are opposite expressions of how absurd and irrational markets can behave. Markets over-react irrationally, driven by the irrational sentiments of fear and greed. Panic drives the Crashes and over-enthusiasm drives the Bubbles.
As Martin Varsavsky said to Tim O-Reilly at the Web 2.0 Expo:
“Markets are bipolar, and they over-emphasize good times and bad times. […] Entrepreneurs need to distinguish Price and Value […] (and) steer in the middle of the tremendous swings of the Market, which are unreal in both ends.”
As “unreal” as Crashes and Bubbles might be, unfortunately they have a real impact in the economy. Stock market prices, or how much companies are valued, should not worry anyone but investors. The reality is different. Stock prices reflect the expectations of how companies are going to perform in the future, more than how they financially perform now. With stock prices plummeting irrationally driven by fear of crash (not by current performance), companies quickly adjust forecasts and cut investments and jobs. Companies show investors how well they anticipate to the changing cycle. This is usually rewarded with a 5% price increase as the measures are announced, followed by 15% down once the downturn is confirmed.
Investment cuts have an immediate effect on the forecast of suppliers that in return also cut investment and jobs in a domino effect that extends throughout the value chain. With more unemployment, no industry is safe from reducing forecasts, and the downturn generalizes, bringing even more pessimism to the Markets. A Crash becomes a self-fulfilling prophecy driven by fear.
Bubbles are just the other extreme, where market irrationally foresee (and analyst justify) exaggerated growth, sometimes even infinite. The gains in stock prices only signal to companies that they need to invests more and grow more. And with everybody foreseeing a bright future, everyone spends more, invests more and take more risks to outpace competition and by doing the stock market goes up and up. It is when price-earning ratios reach 20 for a mature industry and 100 to 1000 for the most trendy industries, that one can sense that the bubble is ready to burst.
Market over-reaction and short-term speculation also amplify the drama. A few weeks ago we had a headline in Spanish newspapers with the biggest loss in history of Madrid’s IBEX down 10% in a day. The next trading day, we had a headline with the biggest ever win of IBEX up 10% in a day.
Analyst are quick to explain the crash and predict apocalypse: 1) Seeing Google stock going down, Om Malik writes “The Sky is Falling” where not only he echoes some analysts concluding that the downturn will hit online ads, but also Om predicts they will find it hard to attract talent!!? 2) TechCrunch on their side echos a VC-rating site that explains that VCs will not make money soon. I wonder why they did not advice it one year ago. It would have been more helpful.
Analysts and economists are great at explaining the future aposteriori (when it is past). At predicting the future apriori (before it happens) they are as accurate as a monkey shooting darts.
Forget analysts, forget economists. Go find the next dream. Hope and work will do.