What is a financial bubble?
The old saying goes “you never know you’re in a bubble until it bursts”, and this is especially true in the stock market. A financial bubble is defined as a period when prices are rising rapidly, exceeding the true or intrinsic value of an asset, market sector, or entire industry, such as real estate.
If you’ve ever seen a child blow soap bubbles, you know how fragile they are. Made from the thinnest film of soapy water, they are filled with nothing but air, so any sudden change or movement, from a gust of wind to a curious touch, will cause them to pop.
Financial bubbles can take years to develop, but although there are a variety of factors behind their formation, they all share one thing in common: they burst, usually quickly, and the consequences can have a devastating global impact.
What causes a financial bubble?
Why do bubbles form, anyway? Different schools of economic thought have their opinions:
- Keynesian economics, based on the twentieth century theories of John Maynard Keys, would indicate speculation, or emotionally driven buying and selling based on demand, earnings growth, or often just potential. These actions are based on the herd mentality or, a phrase coined by Keys, called animal spirits. He believed that when people rely on instinct and feelings to make decisions, their ability to act rationally is distorted. Therefore, when we amplify this impulse by thousands or even millions of times for each investor trading the markets, personal emotion can actually fuel market phenomena such as financial bubbles, runs, sell-offs and even recessions.
- Other schools of thought blame the artificial manipulations of sources such as the Federal Reserve, which manages the economy by printing currency and setting, raising and lowering interest rates. They believe that such interventions can actually harm the market’s natural cycles of growth and contraction.
- In addition, there are the basic microeconomic principles of supply and demand: When a new technological innovation is introduced, it generates a frenzy of interest, or when there are supply shortages, shortages can drive up the price of an asset.
- And to those who subscribe efficient market theorybubbles don’t actually existbecause they believe that prices always reflect intrinsic value.
Whatever the hypothesis, there is one thing everyone agrees on: investors are often unaware that a bubble is brewing until it is too late.
What are the 4 stages of a bubble?
Bubbles materialize in four stages:
- “Smart money” investment: Early stage investors notice new opportunity arising from fundamentals and often build their positions stealthily. The dynamic is accelerating.
- Public awareness: The asset has already risen in value, often significantly, attracting the attention of more traditional investors, including the media. Smart money can sell some of its holdings and volatility increases.
- Max Frenzy: Everyone wants a “piece of the pie,” leading analysts to wonder if the appreciation will last forever or if an end is in sight. Investors use leverage and debt to further increase their positions, often when the asset has become overvalued. Alan Greenspan’s phrase “irrational exuberance” applies here.
- Clearance: A paradigm shift is happening and opinion is changing, for whatever reason. Investors begin to frantically offload their positions and the price of the asset drops sharply and dramatically. Over-leveraged investors can lose big, but smart money can start creating new positions and the cycle can begin again.
Common Types of Bubbles
Generally speaking, financial bubbles belong to distinct categories:
TheStreet Dictionary Terms
- Action bubbles swell around an insatiable demand for tangible assets. An example would be the tech stocks that made up the dotcom bubble of the late 1990s.
- debt bubbles have to do with credit-based or intangible investments. An example of this category would be the corporate bond bubble that took place after the financial crisis of 2007-2008. The consequences of debt bubbles include debt deflationor an increase in defaults, bank failures and even currency collapse.
- Combined bubbles, which occur when equity bubbles are financed by debt, can be particularly devastating. One such example would be the housing market bubble of 2008, which threatened to destroy the US economy and led to a global financial crisis.
What happens when a financial bubble bursts?
Pop goes the bubble! When a financial bubble bursts, demand drops and prices fall quickly, just as water quickly evaporates when a soap bubble bursts. Investors who have established positions near the top could see their profits completely erode.
Depending on its size, a deflating bubble can have short-term effects on an industry or market niche, but it can also lead to broader consequences, like what happened to the real estate market in 2007-2008: the slowdown real estate in the United States. market snowballed into a national recession and led to a global currency crisis. History has proven that compound bubbles, or debt-fueled stock bubbles, are the most serious.
Why is it so difficult to spot a financial bubble?
Maybe he should not being hard to notice that a bubble is brewing – if emotion really moves the markets and investors are driven by fear and greed, then too often they are mistaken into thinking they are seizing a hot opportunity, when in reality they are buying a bubble about to burst. Typically, bubbles occur around a paradigm shift, such as the introduction of new technology – the tech boom of the late 90s, or advancements in the transportation industry in the 19th century, along with canals and railways, are two excellent examples.
So whenever demand increases or someone says, “This is unlike anything we’ve seen before,” it’s wise to take note. Examine the fundamentals behind the stock you are about to buy. Metrics like P/E ratios can help determine if a stock is overvalued.
How do I know if we are in a bubble?
In an effort to shed light on (and extinguish) future financial crises, the Federal Reserve has compiled a list of common indicators that can help identify bubbles and thus minimize their damage.
He even created an “exuberance index,” developed by Pavlidis et. al (2015), which is applied to the housing market. This index measures house prices, price-to-income ratios, and price-to-rent ratios to determine instances of explosive growth. If prices are valued above a critical threshold of fundamentals, this is referred to as “exuberance”.
Some historical financial bubbles
Believe it or not, the first financial bubble was about tulip bulbs. In the 17th century, demand for the cheerful flower caused farmers to experiment with species and colors, and so the tulip became an object of speculation. In fact, they were so popular that people literally mortgaged their homes for Tulip Mania to buy and then resell tulip bulbs. Suddenly, consumer confidence eroded and the tulip market collapsed. They have become almost worthless and many believe they have led to a year-long economic decline throughout the Netherlands.
The 1980s saw an asset bubble in the Japanese real estate market. Prices became inflated by growing demand, limited supply and seemingly endless credit. Speculation was rampant, but by the early 1990s the bubble had burst, leaving Japan’s economy in a state of stagnation that would last nearly a decade.
The sky seemed to be the limit for America’s tech startups in the 1990s. The emergence of the Internet and its many possibilities fueled a wave of investment, as investors were eager to put their dollars into anything that was linked to technology, and prices soared on a low fundamental valuation. When earnings were released, these tech companies hadn’t hit their mark and their stocks plummeted, leaving many bankruptcies.
Are we in a bubble?
RealMoney’s Jim Collins thinks we’re in an “everything bubble” right now. Find out why here.