As an investor, there is nothing more exhilarating than a rising market. However, what if the rising market is becoming an asset bubble ready to burst? Are you smart enough to ride the market high and bail out before it pops? Research says that most people think they are, but that hardly translates into reality.
You can avoid getting caught up in a future asset bubble by understanding what an asset bubble is, its causes, its stages, and its effects on the economy.
What Is an Asset Bubble?
Many economists and analysts disagree on the exact definition of an asset bubble and its causes. However, although each bubble is unique, they share common characteristics such as greed, euphoria, and fear. So, keeping this in mind, asset bubbles refer to events when the price of a commodity or other financial instrument rises to a point where it can no longer be sustained by its underlying fundamentals and intrinsic value. They can show up in a single stock or security or an entire industry or sector.
Asset bubbles are also known as economic bubbles, market bubbles, and financial bubbles.
Because of their complex nature, it isn’t easy to differentiate these asset bubbles from a bullish market. The main problem is that most of us don’t see them coming. Even when warning signs are everywhere, we keep telling ourselves that this time is different. Eventually, the bubble bursts and the asset’s price takes a nosedive. As a result, investors who got in too late and those who got out too late will experience massive losses.
Sometimes, these bubbles even spread to other sectors creating a ripple effect and causing colossal damage to financial markets. For example, the Wall Street crash of 1987 was a huge wake-up call for those who thought the stock market ran efficiently and would keep going up.
The tech bubble, which was caused by excessive speculation of Internet-related companies, was even more devastating. Although in the late 1990s, warnings about this bubble were everywhere, it took years for this Dot-com bubble to burst. Likewise, when the housing bubble crashed, it devastated the real estate market and turned into the 2008 Great Recession.
Possible Causes of Asset Bubbles
As mentioned before, there is no agreement among economists and analysts on what causes asset bubbles. Some believe that bubbles cannot be identified in advance and cannot be prevented from forming. Others believe they can. However, over the years, various contributing factors have been identified. Here are some possible causes of asset bubbles:
Low interest rates and an increase in the money supply – Low interest rates and a larger money supply make credit cheaper resulting in increased demand and increasing prices.
Demand-pull inflation – When the demand for a stock or an asset exceeds the available supply, the price of the asset increases. This is the natural course of economic activity. However, an asset bubble starts growing when people start investing and speculating in anticipation of such inflation.
Asset shortages – A shortage of supply or an expected shortage of supply for an asset increases demand because people will rush to buy as much as possible while it is still available. Then, the supply has a hard time keeping up with the demand. As a result, this will create an imbalance leading to spikes in prices beyond the asset’s original value.
Herd Mentality – It is a naive assumption that when many investors buy a certain asset, it will be a good investment and be profitable. For example, when people see financial experts and banks investing in a particular asset, they often automatically follow suit, assuming it will be a moneymaker. Herd mentality bias refers to investors copying the actions of other investors without doing their own due diligence and analysis. Unfortunately, their decisions are largely based on emotions and greed, not on rationality and the asset’s fundamental value.
“This time is different” mentality – Throughout history, successful market frenzies are often justified by arguing that what happened in the past is no longer relevant. Thus, people believe that things are different and the same thing will not happen again. But, of course, we all know this assumption often proves to be wrong.
Overblown growth stories – During the dot-com bubble, many believed that tech stocks saw S-curve growth levels. Even at present, high-profile growth stocks like electric cars and eCommerce are being pushed with the same hope of continuous growth.
Absence of valuation anchor – Starting with the 17th-century tulip mania, most speculative markets have no ground for valuation. In cases where there is no income to tie to the speculator’s imagination, asset values can go haywire. For example, although in 2013 people were starting to comprehend the concept of cryptocurrency, Bitcoin still increased by 5500 %. This shows how an asset without a firm basis for its value can be driven by speculative forces such as the Fear Of Missing Out (FOMO).
Irrational exuberance – The present cryptocurrency market is a great example of irrational exuberance. Satirical meme coins like Dogecoin, having no utility of their own, rallying 5000 % in less than a year. Another example of irrational exuberance is Non-Fungible Tokens (NFTs) that are selling for millions of dollars. NFTs are digital tokens used to represent ownership of unique digital or physical items, such as art, digital content, etc.
Irrational exuberance is basically the psychological basis for a speculative asset bubble. Asset prices continue to increase because the high returns witnessed by others attract more people. This pushes prices even higher until they eventually reach their limit and the asset bubble bursts.
5 Stages of an Asset Bubble
The American economist, Hyman P. Minsky’s theory of the development of financial instability and its interaction with the economy is now recognized as an explanation for some bubble patterns. He identified 5 stages bubbles go through.
Asset bubbles are unsettling and highly unpredictable events. However, understanding the various stages an asset bubble usually goes through allows investors to prepare and be ready for them.
The five stages of an asset bubble’s lifecycle are displacement, boom, euphoria, profit-taking, and panic.
Displacement occurs when investors want to partake in the new shift in the economy. For example, this shift can occur when many investors start investing in a technological breakthrough or taking advantage of historically low interest rates.
Initially, stock prices first start rising at a slow pace, and then a displacement occurs. After this displacement, momentum will typically increase. Then the market will see more and more investors jumping on board to take advantage of the upcoming boom phase. This phase essentially attracts media attention and creates the fear of missing out (FOMO). This leads to even more speculation, attracting more and more traders and investors to want a piece of the pie.
In the euphoria phase, caution goes out of the window as prices of the assets reach new highs. Investors will start considering newer metrics and ways to value the asset to justify the sudden price increase. The “greater fool” narrative shows up everywhere. Many buyers will still be willing to pay more for these assets no matter what direction the price goes.
For example, at the peak of the “Internet Bubble,” the value of all technology stocks combined was higher than most countries GDP. This certainly was a sign that their valuation was way off. However, greed and euphoria were stronger than the stocks’ real value, and investors kept investing in tech stocks.
Warning signs that the bubble is about to pop emerge in the profit-taking phase. This is the phase when market mavens sell their positions and book their profits. This is often the first sign of the market unraveling. Unfortunately, most retail investors and amateur speculators miss this sign, resulting in big losses for them when the asset bubble bursts.
It does not take much for a bubble to pop and collapse. Once it pops, it cannot be inflated again. In this phase, asset prices start reversing. They drop as quickly as they went up, and investors start to lose confidence. Then, panic kicks in, and they want to get out. At this point, many of them are willing to liquidate their assets at any price.
How to Identify an Asset Bubble?
It is tough to recognize a bubble while it’s happening because price increases in a market are often just a sign of a bullish market.
The key to identifying a bubble is the ability to differentiate consistent, sustainable growth from spiraling prices. So valuing a company’s fundamentals plays a key role in identifying a bubble.
If asset prices increase without any changes in their key performance indicators or macroeconomic factors such as supply and demand, mere speculation most likely is the cause of these price increases.
Types of Asset Bubbles
In theory, there can be countless types of asset bubbles. After all, speculative chaos can happen for almost anything. However, there are four main types of asset bubbles:
Stock Market Bubbles – These include equities that rapidly grow in price disproportionately to their company’s earnings and fundamental values.
Market Bubbles – These bubbles form in industries that fall outside of the equities market. For example, when the housing market sees a massive spike in home prices without corresponding correlation to supply and demand changes. In other words, when home prices significantly increase without a change in the number of people renting or buying houses.
Credit Bubbles – A sudden rise in consumer and business loans, debt instruments, or any other type of credit can result in credit bubbles. Examples of types of credit that created credit bubbles in the past include house mortgages, student loans, corporate loans, and government bonds.
Commodity Bubbles – Commodity bubbles form when the price of one or several commodities sees a rapid increase, without any changes in the supply or demand side of said commodities.
In all 4 types of bubbles, price increases are typically the result of speculative interests.
Examples of Famous Asset Bubbles
Tulip Mania Bubble (1630s)
One of the first recorded asset bubbles was the Tulip Bubble in the Netherlands. The tulip trade started as a luxury item for the gardens of the affluent. Soon, instead of importing bulbs from Turkey, the Dutch figured out that tulips could grow from seeds/buds that grew on the mother bulb. As a result, they started growing bulbs themselves as everyone wanted to participate in the tulipmania. They even learned they could grow multicolored bulbs and the prices for these rare bulbs skyrocketed.
In the early 1630s, they reached an all-time high. Bulb trading became so popular that professional traders started popping up, resulting in special bulb trading markets. At some point, the price of some bulbs surpassed the price of a house. Many people started realizing that the market was out of control. Then, in 1637, the market crashed. Traders had bought bulbs on credit, and when prices started declining, they had no choice but to sell at very low prices and liquidate their business. Unfortunately, this left many commoners and speculators bankrupt.
Stock Market Bubble (1920s)
The stock market crash of 1929 was one of the most significant events of the 20th century, leading to the Great Depression that lasted nearly a decade.
This crash can be attributed to the US stock markets’ massive growth during the 1920s. Over-zealous investors fueled this growth with irrational confidence in the equity markets and the US economy. As a result, the market continued expanding until Black Tuesday, October 29, 1929. Then, a record 16 million shares were traded in a single day, with investors losing $14 billion worth of wealth in a single day.
Dot-com Bubble (1990s)
In the early 1990s, the world witnessed the emergence of internet-based startups. Companies such as Google and Amazon started their incredible journey. Unfortunately, there were also many tech startups with no real long-term vision and no innovative products. Since internet penetration was still in the early stages, most tech startups struggled to turn a profit.
However, billions of dollars backed these startups because of investors’ greed and the dot-com industry mania. Most of these investments were not based on solid fundamental investment analysis but rather fuelled by a fear of missing out on this trend. Investors ignored important metrics such as the Price-to-Earnings ratios and just focused on a company’s potential technological advancements. By the late 1990s, tech companies dominated the market. A record number of them went public through initial public offerings (IPOs).
In 1995, while this tech bubble was growing, the Federal Reserve started an expansionary monetary policy in response to the Mexican debt crisis. As a result, it started increasing the money supply and decreasing interest rates. Due to the dot-com craze and the low interest rates, the Nasdaq grew exponentially. The Nasdaq, a market index that mainly tracks growth stocks such as tech stocks, rose by more than 400 % between 1995 and March of 2000.
Then in 2000, The Fed started raising interest rates, Japan entered a recession, and the media started reporting negative tech news. Failed mergers between tech companies, tech companies in financial trouble, and looming antitrust cases against some of the biggest tech companies were just some of the topics. Ultimately, the startups’ performances couldn’t keep up with their valuations and increasing investor expectations, and the financial bubble burst. Billions of dollars in wealth evaporated within just a few weeks.
US Real Estate Bubble (2000s)
For decades, real estate prices in the U.S. increased, although there were some short-term slowdowns due to increased interest rates. Owning real estate had been the major contributor to increased wealth, and homeownership became part of the American dream. However, in the early 2000s, the Fed’s monetary expansion increased the money supply and reduced its target interest rate to historic lows. This led to some inappropriate lending practices, which opened the door to “new creative” home loan products and credit derivatives.
Houses started selling like hotcakes because lenders in the subprime mortgage market were fiercely competing with one another. They approved mortgages for people with no jobs, no income, and no asset verification (NINJA loans). In addition, government-sponsored programs by Fannie Mae, Freddie Mac, and others were offering mortgages to a much wider range of consumers than ever before. This increased demand drove housing prices up, which resulted in further expanded subprime lending to people who couldn’t afford the loans and an increase in speculative investing by banks.
Meanwhile, between 2004 and 2006, the Federal Reserve started increasing interest rates to curb inflation. As a result, borrowers started defaulting on their loans which led to foreclosures and declining housing prices. This, in turn, resulted in the housing bubble bursting in 2006. The housing market crash triggered the Great Recession in 2008 and had a far-reaching negative impact on most people and the economy. As a result, many people lost their jobs, homes, and equity in their homes, and many lenders, banks, and insurance companies went out of business.
What Happens When an Asset Bubble Bursts?
Staying true to its name, a bubble eventually bursts, causing massive sell-offs and a dramatic decline in prices. When this happens, the entire industry or market takes a nosedive, and assets plummet.
An economic bubble bursts when a major source of funding dries up. Asset bubble bursts can have wider damages, especially if it involves a key economic sector such as the housing market or the stock market. It can wipe out a large amount of wealth in no time and cause a financial crisis and a total economic collapse.
During the real estate bubble of 2008, credit contraction was the key culprit. As housing was the key source of wealth for most individuals, this crash affected people in every corner of the global economy. As a result, housing prices fell rapidly, along with a fall in consumer spending. Both of these contributed to a slowdown and recession in much of the global economy.
When a stock market bubble bursts, also commonly known as a market crash, it destroys investors’ wealth. As a result, numerous publicly listed companies may be forced into liquidation or bankruptcy depending on their leverage.
A commodity bubble burst may have different effects on the economy. For example, gold prices falling rapidly may lead to some investors losing money but not all. However, when oil prices fall, it will increase the disposable income of many consumers, which will help the economy as a whole.
Tips on Investing During an Asset Bubble
In general, investing early during the displacement stage, holding on to the asset until the euphoria stage, and selling it during the beginning of the profit-taking phase is the best way to capitalize on an asset bubble. Therefore, it is crucial to get out of the asset bubble before the demand for the asset class plummets and prices crash. Here are some tips on how to invest during a bubble.
Identification – The first step to investing during a bubble is to understand the various stages of the bubble so that you can identify when a bubble is forming. The trick is to keep an eye on new developments or technologies that offer solid market potential. Smart investors jump in early before media coverage drives the prices up. Then, they follow the different stages of the bubble and get out in the profit-taking phase before the price starts to decline.
Protection – Avoid timing the market. Instead, take measures to protect your holdings. For example, invest in companies that have strong fundamental values and financials.
A good strategy would be to look for companies that consistently produce profits, have high equity returns, and have good long-term prospects. Financial metrics such as a low debt-to-equity ratio and a high PEG ratio (Price-to-Earnings Growth) can be good indicators of a safe investment.
Dollar-cost-averaging strategy – Buying and selling assets at regular intervals at a fixed dollar amount regardless of share price or market performance provides more protection against the risks of asset price bubbles. Dollar-cost-averaging is an investment strategy that aims to reduce the impact of volatility on purchases of financial assets. It allows you to buy more equities when the price is low.
Diversify your portfolio – A diversified portfolio across various asset classes and securities is mostly protected from an asset-specific bubble. Keep a close eye on the fundamental values, so you’ll know when a stock exceeds its intrinsic value.
Diversification does not guarantee that you will always fetch profits, nor does it protect you against losses in a declining market. Instead, it will only manage the risks associated with your investment.
Rebalancing your portfolio – It is smart to check your portfolio and rebalance it at regular intervals according to the target asset allocation in your financial plan. While rebalancing, you should also periodically consider re-allocating assets. Allocating with a long-term view may fetch you a higher profit. However, please always consider tax and transaction costs while figuring out a rebalancing and re-allocating strategy.
Asset bubbles are a recurring feature of the modern economy. Although there is disagreement on their causes, asset bubbles refer to events when the prices of commodities or financial instruments rise to a level where they can no longer be sustained by their underlying fundamental value or intrinsic value. Thus, in an asset bubble, prices are often volatile and cannot be explained by changes in demand and supply.
Unfortunately, a bubble is often only identified after the fact, once the bubble has already burst. The fact that an asset bubble is hard to predict makes bubble identification that much more crucial.
The current threat of inflation could potentially burst some of today’s potential bubbles, such as the housing, stock, and cryptocurrency bubbles. In these uncertain times, when the economy is still recovering from the Covid pandemic, it is essential to focus on signs of impending bubble bursts. Another way to prevent losses when an asset bubble bursts is to ensure that your portfolio is diversified and rebalanced.
Bubbles, Financial Crises, and Systematic Risk, by Markus K. Brunnermeier and Martin Oehmke, Working paper 18398, National Bureau of Economic Research (NBER), September 2012.