Definition, examples, why it is important

  • A foamy market describes conditions where stock prices artificially rise based on market sentiment, not trading fundamentals.
  • Excitement and novelty are the main drivers of market foam, as people invest out of fear of missing out on an opportunity to make money.
  • When demand becomes too much to support, bubbling markets can spawn bubbles that eventually burst.
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Wall Street is full of all kinds of jargon that you are likely to hear in news reports or in conversation, but may not fully understand. One such term you’ve probably heard is “sparkling market.”

What is a sparkling market?

When you think of the word foam, you probably imagine something like the foam that rises to the top of a mug when beer is spilled, or the dessert recipe with instructions for whipping egg yolks and sugar into a foam.

In the markets, the froth is when investors are thrown into such a frenzy that they ignore fundamentals and cause stock prices to far exceed their intrinsic value.

“Market froth occurs when there is excitement about developing new technologies or new products,” says Dan North, chief economist at Euler Hermes North America. “Such developments tend to make investors feel like they are entering the bottom floor of the next big thing, or that they have a once-in-a-lifetime opportunity to ‘get rich quick.’ This forces investors to think that they have to buy now before someone else finds out, which drives the price up.”

Sparkling markets are highly volatile and unpredictable. The price increase they produce is also unsustainable. The froth often leads to market bubbles that, as history has shown, eventually burst, devastating investors and derailing the economy.

While the concept has been around for a long time, the term market foam became popular on Wall Street around 2005, when Federal Reserve Chairman Alan Greenspan described local housing markets in the US as showing “signs of foam” but that a “bubble” in house prices for the nation as a whole was unlikely. in home prices turned out to be wrong within a few years, when mortgage companies found themselves with millions of foreclosures after more than a decade of subprime lending.

Demand for homes had risen rapidly in the frothy market as loans became more accessible to consumers, many of whom couldn’t afford them. Prices skyrocketed and a bubble was created. When homeowners began defaulting on their mortgages in large numbers, the housing market bubble burst and lenders found themselves in significant financial trouble. The domino effect on the markets and the economy pushed the US to its worst.


recession

from the Great


Depression

.

How foam works and how to detect it in the market

Overconfidence is often the driving force behind the market froth. Trends, novelty, changes in market conditions and speculation about the future value of products or technology can lead to foam. investors buy share, betting that their value will increase rapidly and they will be able to make a big profit. However, these investments are not made based on business metrics that indicate the value of an asset, such as price-earnings ratios (PE), income and cash flow.

The most common cause of market froth “is an unjustifiable level of exuberance over an asset,” says Saumen Chattopadhyay, chief investment officer at OneDigital Retirement + Wealth.

A bubble can often be an unintended consequence of monetary policies like low interest rates or big stimulus programs, or a product on the market that gets a lot of hype, says Chattopadhyay. “Typically, one or more of these factors are at play, compounded by investors not missing out (or unable to) miss out on upside returns and/or inexperienced investors not fully recognizing the intrinsic value of an investment asset. dice”.

It can be difficult to spot market froth in real time, but there are a few indicators that can point to this type of market:

1. Excessively rich valuations

Stock prices rising to previously unseen valuations without any appreciable difference in the company’s earnings, products, or services can be a sign of froth in the market.

This happened in 2021 when GameStop’s stock market value jumped from $2 billion to $24 billion in the course of a few days. The company had not become more valuable. But a large surge in demand caused the stock price to jump from $18.84 per share on December 30, 2020, to an all-time high of $347.51 on January 27, 2021. By February 18, the shares had dropped to $40.64. The bubble had burst.

2. Extreme investor exuberance

One of the main drivers of the GameStop froth was the extreme exuberance among retail investors to beat hedge fund investors at their own game. They banded together via social media to artificially inflate GameStop’s stock price so that hedge funds betting on the value going down would lose money on short trades.

cryptocurrency markets they have also seen significant and rapid growth due to the novelty and excitement of this alternative to fiat money. There is no intrinsic value for cryptocurrency, only speculations about its future value. This market has grown incredibly fast, but has already shown that it can collapse just as quickly.

3. Extended period of well above average returns

When markets or indices show returns that are well above their historical average, the foam could be in play. For example, when the dotcom bubble began to grow between 1995 and 2000, both the nasdaq compound and S&P 500 delivered returns of more than double their long-term averages. We now know that tech stocks were overly inflated during this period and that is what was reflected in these unusual returns.

4. Media excitement about the stock market

Media and analysts will report on the market


volatility

, especially when big profits are being made. This information is spread far and wide, especially through social media, and helps create excitement among investors that there are opportunities to make quick and easy money, but you have to move fast to benefit.

“When ‘wow’ stories about newfound riches in the stock market appear on the covers of nonfinancial news magazines, it’s a sign of a bubbling market,” says North. “When your UBER driver tells you about his stock, the foam boils over. When the UPS guy is checking stock prices as you ride with him in the elevator and loudly announces how well the market is doing of stock, see below.”

The market froth before the dot-com crash

One of the best known cases of market foam occurred at the end of the 20th century. The advent of the Internet and e-commerce was rapidly changing the world, causing a wave of excitement among investors and venture capitalists about all the new technologies hitting the market.

Investment in Internet-linked technology companies skyrocketed between 1995 and 2000. At the time, Nasdaq listed many technology stocks, which quickly became overvalued as demand increased. Venture capitalists, lenders and investors poured money into the sector primarily based on speculation about how the companies they invested in would fare in the future, not on traditional valuation measures.

“During the wild exuberance of the dot-com bubble from the mid-1990s to 2000, many new technology companies made no profits or, in some cases, even sales, yet their stock prices soared” North says. “Those valuations were based on investors’ irrational sentiment that these companies showed unlimited profit potential in exciting new technology that was sure to make them rich.”

The reality was that many of these companies were not based on sound business models and used metrics that were disconnected from the real fundamentals, such as revenue, profit, and cash flow to drive investment.

This was not sustainable and the bubble that this frothy market created burst when companies were unable to produce enough profits. The tech Nasdaq lost 74% of its value between 2000 and 2003 and took 15 years to fully recover. the S&P 500 it lost 50% of its value during this same time and took about five years to recover.

“When these foamy bubbles burst, the results can be excruciatingly painful,” says North.

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