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The Denial Stage in a Financial Bubble

Published by Lawrence Roberts | December 26th 2008 | Views:

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There are many identifiable stages in a financial mania. These include: enthusiasm, greed, delusion, denial, fear, capitulation, and despair. When the limit of affordability is reached and the pool of available buyers is exhausted, prices start to decline. At first market participants are still overwhelmed by greed, and they choose to ignore the signs that the party might be over.

In 2007 most real estate markets were in the denial stage as prices had not dropped enough to cause real fear. Denial is apparent in polls in mid-2007 where 85 percent believed their home would rise in value during the next five years, and 63 percent believe a house is a good investment. That is denial.

It is also apparent in the number of homes purchased during the greed stage that are held for sale at breakeven prices, even if this is above market. When the inventory is large, and houses stay on the market for a long time, prices are too high. Sellers who refuse to lower their prices to take a small loss are in denial about the state of the market. They believe bids will increase and some buyer will come along and pay their price, after all, that is the way it was just a couple of years prior.

Buyers who bought in the enthusiasm stage are still ahead, so they feel no urgency to sell. They have made good money already and they will hold on with hopes of making a little more. Since they believe the asset will appreciate again (and they have nrealistically priced houses starts to build a large inventory of homes "hanging" over the market. Overhead supply is a condition in a financial market when many units are held for sale at prices above current market prices.

Generally there will be a minor rally after the first price decline as those who missed the big rally but still believe prices will only go up enter the market and cause a short-term increase in prices. This is a bear rally. It is aptly named as those bullish on the market buy right before the bear market reverses and quickly declines.

For prices to resume a sustained rally, the overhead supply must be absorbed by the market. Once prices stopped going up and actually began to fall, demand is lessened by diminished buyer enthusiasm and the contraction of credit caused by mounting lender losses. With increasing supply and diminished demand prices cannot rally to absorb the overhead supply. The overall bullish bias to market psychology has not changed much at this point, because owners are in denial about the new reality of the bear market; however, the insufficient quantity of buyers and the beginnings of a credit crunch signal the rally is over and the bubble has popped.
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