Definition, examples, why it matters
- A foamy market describes conditions where stock prices artificially rise based on market sentiment and not company fundamentals.
- Excitement and novelty are the main drivers of market excitement as people invest out of fear of missing out on an opportunity to make money.
- When demand becomes too much to bear, frothy markets can lead to bubbles that eventually burst.
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Wall Street is filled with all kinds of jargon that you’ll probably hear in news reports or in conversation, but might 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 cup when the beer it contains is spilled, or the dessert recipe with instructions for whipping egg yolks and sugar in a mousse.
In markets, foam occurs when investors are swept into such a frenzy that they ignore fundamentals and push stock prices far beyond their intrinsic value.
“Market scum occurs when there is enthusiasm for the development of new technologies or new products,” says Dan North, chief economist at Euler Hermes North America. “Developments like these tend to make investors feel like they’re entering the ground floor of the next big thing, or having a once-in-a-lifetime ‘get-rich-quick’ chance. This forces investors to think that they have to buy now before anyone else hears about it, which drives up the price.”
Sparkling markets are very volatile and unpredictable. The price increase they produce is also unsustainable. Foam often leads to market bubbles which, as history has shown, eventually burst, devastating investors and derailing the economy.
Although the concept has been around for a long time, the term market foam was popularized on Wall Street around 2005, when Federal Reserve Chairman Alan Greenspan described local real estate markets in the United States as showing “signs of foam”. “, but that a “bubble” in real estate prices for the whole country” was unlikely. He was right. But Greenspan’s prediction of a real estate price bubble turned out to be incorrect in a few years back, when mortgage companies found themselves with millions in foreclosures after more than a decade of subprime lending.
Demand for housing had grown rapidly in the frothy market as loans became more accessible to consumers, many of whom could not afford them. Prices soared and a bubble was created. When homeowners began to default on their mortgages in large numbers, the housing market bubble burst and lenders found themselves in financial difficulty. The ripple effect in markets and the economy has pushed the United States into its worst
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How foam works and how to spot it in the market
Overconfidence is often the driving force behind market scum. Trends, novelty, changes in market conditions, and speculation about the future value of products or technology can all cause a stir. Investors buy stocks, betting that their value will rise quickly and they can make a large profit. However, these investments are not made based on business measures that indicate an asset’s value, such as price-earnings (PE) ratios, earnings, and cash flow.
The most common cause of market scum “is an unjustifiable level of exuberance about an asset,” says Saumen Chattopadhyay, chief investment officer at OneDigital Retirement + Wealth.
A bubble can often be an unintended consequence of monetary policies such as low interest rates or large stimulus programs, or a product in the market that receives a lot of hype, Chattopadhyay says. “Usually one or more of these factors are at play and combine with investors who don’t miss (or can’t) miss the upside returns and/or inexperienced investors who don’t fully recognize the intrinsic value of a given investment asset.”
It can be difficult to spot market foam in real time, but there are a few indicators that can signal this type of market:
1. Excessively rich valuations
Stock prices rising to previously unseen valuations without any appreciable difference in company earnings, products or services can be a sign of market scum.
This happened in 2021 when the market value of GameStop shares went from $2 billion to $24 billion in a matter of days. The business had not gained in value. But a sudden and dramatic increase in demand caused the stock price to soar from $18.84 per share on December 30, 2020 to an all-time high of $347.51 on January 27, 2021. On February 18, shares were fell to $40.64. The bubble had burst.
2. Extreme investor exuberance
One of the main drivers of the GameStop foam was the extreme exuberance of 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 that bet on falling value lose money on short trades.
Cryptocurrency markets have also seen significant and rapid growth due to the novelty and excitement of this alternative to fiat currency. There is no intrinsic value to cryptocurrency, only speculation as to its future value. This market has grown incredibly fast, but has already shown that it can crash just as quickly.
3. Extended period of well above average returns
When markets or indices are posting returns well above their historical average, foam can be in play. returns more than twice their long-term averages. We now know that tech stocks were overinflated during this time and that was reflected in these unusual returns.
4. Media enthusiasm for the stock market
Media and analysts will report on the market
, especially when there are huge gains going on. This information is spreading very widely, especially via social media, and is helping to get investors excited about the fact that there are opportunities to make money quickly and easily, but you have to act fast to benefit from it.
“When ‘wow’ stories about newly created wealth in the stock market appear on the covers of non-financial news magazines, that’s a sign of a bubbly market,” says North. “When your UBER driver talks to you about his stocks, the foam boils over. When the UPS guy checks stock prices while you ride with him in the elevator and he announces out loud how he’s doing well on the stock market, look below.”
Market scum before the dot-com crash
One of the best known examples of market foam occurred towards the end of the 20th century. The advent of the Internet and e-commerce has rapidly changed the world, causing a wave of excitement among investors and venture capitalists about all the new technologies that come to market.
Investment in Internet-related technology companies boomed between 1995 and 2000. At the time, the Nasdaq listed many technology stocks, which quickly became overvalued as demand grew. Venture capitalists, lenders and investors poured money into the sector primarily based on speculation about how the companies they invested in would perform in the future, not on measures of traditional assessment.
“During the savage exuberance of the dot-com bubble of the mid-1990s through 2000, many new technology companies made no profit or, in some cases, no sales, but their stock prices soared” , says North. “These valuations were based on investors’ irrational sentiment that these companies had unlimited profit potential in an exciting new technology that would surely make them wealthy.”
The reality was that many of these companies were not built on sound business models and used metrics disconnected from real fundamentals such as revenue, earnings, and cash flow to drive investment.
This was not sustainable and the bubble created by this frothy market burst when companies could not produce enough profits. Nasdaq tech lost 74% of its value between 2000 and 2003 and took 15 years to fully recover. The S&P 500 lost 50% of its value over that same period and took about five years to recover.
“When those frothy bubbles burst, the results can be terribly painful,” says North.