Definition, examples why it matters

  • A foaming market describes conditions in which stock prices artificially rise based on market sentiment, not business fundamentals.
  • Excitement and novelty are the main drivers of the market rally as people invest fearing they are missing out on a money-making opportunity.
  • When demand becomes too great to bear, seething markets can create bubbles that eventually burst.
  • Read more stories from Personal Finance Insider.

Wall Street is full of jargon that you probably hear on the news or in conversation but might not fully understand. One such term you’ve probably heard is “frothy market”.

What is a foam market?

When you think of the word foam, you probably picture something like the foam that rises to the rim of a mug as the beer sloshes around in it, or the dessert recipe with instructions for beating egg yolks and sugar into foam.

The markets froth when investors are thrown into such a frenzy that they ignore fundamentals and drive stock prices well above their intrinsic value.

“Market foam occurs when there is excitement about developing new technology or new products,” said Dan North, chief economist at Euler Hermes North America. “Such developments give investors the feeling that they are getting the bottom tier of the next big thing or a once-in-a-lifetime ‘get rich quick’ opportunity. This forces investors to think they need to buy now before anyone finds out what’s driving the price up.”

Foamy 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, wreaking havoc on investors and derailing the economy.

Although 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 US housing markets as “signs of foam,” but that it was a “bubble” acted. in house prices for the nation as a whole” was unlikely. He got the foamy part right. But Greenspan’s prediction of a bubble in house prices was proven wrong within a few years, as mortgage lenders faced millions in foreclosures more than a decade later of risky loans.

Demand for homes had grown rapidly in the seething market as credit became more accessible to consumers, many of whom could not afford to pay. Prices rose and a bubble ensued. As homeowners defaulted on their mortgages in large numbers, the housing bubble burst and lenders faced significant financial difficulties. The ripple effect on the markets and in the economy has pushed the USA into its most difficult phase


recession

since the big one


depression

.

How foam works and how to recognize it in the market

Over-confidence is often the driving force behind market frothing. Trends, novelties, changes in market conditions, and speculation about the future value of a product or technology can all create foam. Investors buy stocks, betting that their value will increase quickly and they can make a big profit. However, these investments are not made based on business metrics that indicate the value of an asset, such as: B. Price to Earnings (PE), Revenue and Cash Flow.

The number one cause of market falls “is an unwarranted exuberance about an asset,” says Saumen Chattopadhyay, chief investment officer at OneDigital Retirement + Wealth.

A bubble can often be an unintended consequence of monetary policy, such as low interest rates or big stimulus programs, or a product in the market that’s getting a lot of hype, Chattopadhyay says. “Typically, one or more of these factors play a role and come with investors who either can’t (or can’t) miss the upsides and/or inexperienced investors who don’t fully appreciate the intrinsic value of a particular asset.”

Spotting market foams in real-time can be difficult, but there are a few indicators that can signal this type of market:

1. Overly rich reviews

Stock prices rising to unprecedented valuations without significant differences in a company’s earnings, products or services can be a sign of market conquest.

This happened in 2021, when the market value of GameStop stock soared from $2 billion to $24 billion in a matter of days. The company had not increased in value. But a sudden huge surge in demand took the share price from $18.84 per share on December 30, 2020 to an all-time high of $347.51 on January 27, 2021. By February 18, shares had fallen to $40.64. The bubble had burst.

2. Extreme investor exuberance

One of the main reasons for the GameStop foam was the extreme enthusiasm among retail investors to beat hedge fund investors with their own resources. They teamed up on social media to artificially inflate the price of GameStop stock so that hedge funds betting the value would go down would lose money on short trades.

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

3. Extended returns period well above average

When markets or indexes are posting returns well above historical averages, foam can be at play. For example, when the dot-com bubble began to swell between 1995 and 2000, both the Nasdaq Composite and the S&P 500 were delivering returns more than double their long-term averages. We now know that technology stocks were overvalued during this period, and that 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 wins are made. This information is spreading far and wide, particularly via social media, and is helping to create investor excitement that there are ways to make money quickly and easily, but you have to move fast to capitalize on them.

“When ‘wow’ stories about new wealth in the stock market hit the covers of non-financial news magazines, it’s a sign of a seething market,” says North. “When your UBER driver tells you about his stock holdings, it overflows. When the UPS guy is checking the stock prices while you ride him in the elevator and he’s loudly shouting about how well he’s doing in the stock market, look down.”

Market upleg before dot-com crash

One of the most famous cases of market foam occurred in the late 20th century. The advent of the internet and e-commerce quickly changed the world, creating a wave of excitement among investors and venture capitalists about all the new technologies coming to market.

Investments in technology companies connected to the Internet skyrocketed between 1995 and 2000. Back then, the Nasdaq listed many tech stocks that quickly became overvalued as demand increased. Venture capitalists, lenders and investors poured money into the sector based largely on speculation about how the companies they invested in would fare in the future, rather than on traditional valuation metrics.

“During the wild exuberance of the dot-com bubble from the mid-1990s to the 2000s, many new technology companies had no profits, or in some cases no sales, yet their stock prices soared,” says North. “These valuations were based on investors’ irrational sense that these companies demonstrated limitless earnings potential in an exciting new technology that would surely make them rich.”

The reality was that many of these companies weren’t built on solid business models and used metrics disconnected from real fundamentals like sales, earnings, and cash flow to drive investments.

This was unsustainable and the bubble created by this seething market burst when companies failed to generate enough profits. Tech-Nasdaq 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 the same period and took about five years to recover.

“When those frothy bubbles burst, the results can be excruciatingly painful,” says North.

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