What Is a Financial Bubble?
The old saying goes “you never know you’re in a bubble until it bursts,” and that is especially true in the stock market. A financial bubble is defined as a period when prices rise rapidly, outpacing the true worth, or intrinsic value, of an asset, market sector, or an entire industry, such as real estate.
If you’ve ever watched a child blowing soap bubbles, you know how fragile they are. Made from the thinnest film of soapy water, they’re filled with nothing but air, and so any change or sudden movement, from a gust of wind to a curious touch, will cause them to pop.
Financial bubbles can take years to develop, but while there are a variety of factors behind their formation, they all share one thing in common: they burst, usually quickly, and the consequences can leave a devastating global impact.
What Causes a Financial Bubble?
Why do bubbles form, anyway? Differing schools of economic thought have their opinions:
- Keynesian economics, based on the 20th-century theories of John Maynard Keys, would point to speculation, or emotion-driven buying and selling based on demand, earnings growth, or often mere potential. These actions are based on herd mentality or, a phrase Keys coined, called animal spirits. He believed that when people rely on instinct and feelings to make decisions, their ability to act rationally becomes distorted. Therefore, when we magnify this impulse by many thousands if not millions of times for every investor trading the markets, personal emotion can actually fuel market phenomena such as financial bubbles, run-ups, selloffs, and even recessions.
- Other schools of thought blame artificial manipulations from sources like the Federal Reserve, which manages the economy by printing currency and setting, raising, and curbing interest rates. They believe such interventions can actually hurt 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 shortfalls, the shortages can drive an asset’s price skyward.
- And to those who subscribe to efficient market theory, bubbles actually don’t exist, because they believe that prices always reflect intrinsic value.
Whatever the hypothesis, there is one thing that everyone can agree on: investors are oftentimes unaware that a bubble is brewing until it’s too late.
What Are the 4 Stages of a Bubble?
Bubbles materialize through four stages:
- “Smart money” investment: Early-in investors notice a new opportunity arising from the fundamentals and often stealthily build their positions. Momentum accelerates.
- Mainstream awareness: The asset has already increased in value, often significantly, triggering attention from more mainstream investors, including the media. The smart money may sell some of its holdings, and volatility increases.
- Peak frenzy: Everyone wants a “piece of the pie,” triggering analysts to wonder whether 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” is applicable here.
- Selloff: A paradigm shift occurs, and opinion changes—whatever the reason. Investors begin frantically offloading their positions, and the asset’s price falls steeply and dramatically. Overleveraged investors can lose big, yet the smart money may begin building new positions, and the cycle may begin again.
Common Types of Bubbles
Generally speaking, financial bubbles fall into distinct categories:
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- Equity bubbles inflate around insatiable demand for tangible assets. One example would be the technology stocks that made up the dot com bubble of the late 1990s.
- Debt bubbles have to do with credit-based, or intangible, investments. One example from 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 deflation, or a rise in loan defaults, bank failures, and even currency collapse.
- Combination bubbles, which occur when equity bubbles are financed with debt, can be especially devastating. One such example would be the housing market bubble of 2008, which threatened to destroy the U.S. 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 falls, and prices decline quickly, just like water evaporates rapidly when a soap bubble is popped. Investors who established positions near the top could see their profits erode completely.
Depending on its size, a deflating bubble can have short-term effects to an industry or market niche, but it could also prompt bigger-picture consequences, such as what happened to the housing market in 2007–2008: The downturn in the U.S. housing market snowballed into a national recession and led to a global monetary crisis. History has proven that combination bubbles, or equity bubbles fueled by debt, are the most severe.
Why Is It So Hard to Spot a Financial Bubble?
Perhaps it shouldn’t be hard to notice a bubble brewing—if emotion really does move the markets, and investors are compelled by fear and greed, then all too often, they fool themselves into thinking they are seizing on a hot opportunity, when in reality, they’re buying a bubble about to burst. Typically, bubbles occur around a paradigm shift, such as the introduction of a new technology—the tech boom of the late 90s, or advancements made in the 19th Century transportation industry, with canals and railroads, are two great examples.
So whenever demand surges or someone says, “this is unlike anything we’ve ever seen before,” it’s wise to take note. Examine the fundamentals behind the stock you’re about to purchase. Metrics like P/E ratios can help determine if a stock is overvalued.
How Can I Tell If We’re in a Bubble?
In an effort to shed light on (and extinguish) future financial crises, the Federal Reserve has put together a list of common indicators that can help identify bubbles and thus minimize their damage.
It has even created an “Exuberance Index,” developed by Pavlidis et. al (2015), which is applied to the housing market. This index measures housing prices, price-to-income-ratios, and price-to-rent ratios to determine instances of explosive growth. If prices are rated higher than a critical threshold of fundamentals, there is said to be “exuberance.”
A Few Historical Financial Bubbles
Believe it or not, the first financial bubble had to do with tulip bulbs. In the 17th century, demand for the cheerful flower caused farmers to experiment with species and coloring, and so the tulip became an object of speculation. In fact, they were so prized, people literally mortgaged their homes during Tulip Mania in order to buy and then resell tulip bulbs. Suddenly, consumer confidence eroded, and the market for tulips crashed. They became all but worthless and many believe they led to a year’s-long economic decline throughout the Netherlands.
The 1980s witnessed an asset bubble in Japan’s real estate market. Prices became inflated from surging 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 fledgling U.S. technology companies in the 1990s. The emergence of the internet and its many possibilities fueled a surge of investment—as investors were eager to place their dollars into anything tech-related, and prices soared on little fundamental valuation. When earnings were reported, these tech companies had fallen short of their mark, and their stocks crashed, leaving many bankrupt.
Are We In a Bubble?
RealMoney’s Jim Collins believes we are currently in an “everything bubble.” Find out why here.