What Exactly Is a Bubble?
A fundamental feature of financial bubbles is the suspension of disbelief by most participants during the speculative price surge: They are only realised in retrospect after the bubble has burst (much to the despair of many an investor). Nonetheless, some economists have identified five stages of a bubble—a pattern to its development and fall—that may help the unwary avoid falling prey to its seductive grasp.
In economics, the phrase “bubble” refers to a scenario in which the price of something—a single stock, a financial asset, or could be an entire sector, market, or asset class—significantly exceeds its underlying value. Because speculative demand, rather than fundamental value, fuels inflated prices, the bubble gradually but inevitably bursts, and enormous sell-offs cause prices to fall precipitously, frequently rather dramatically. Indeed, in most situations, a speculative bubble is followed by a catastrophic crash in the underlying securities.
Asset Bubbles of Various Types
Asset bubbles can be classified into four broad categories:
Stock market bubbles involve equities—shares of corporations that experience rapid price growth, frequently out of proportion to their intrinsic value (earnings, assets, etc.). These bubbles can affect the broader stock market, exchange-traded funds (ETFs), or specific fields or market sectors—for example, Internet-based enterprises, which powered the late 1990s dot-com bubble.
Outside of the equity market, asset market bubbles affect other industries or sectors of the economy, and real estate is a well-known illustration. Currency run-ups, whether in traditional currencies such as the US dollar or euro or cryptocurrencies such as Bitcoin or Litecoin, could also be classified as bubbles.
Credit bubbles occur when consumer or company loans, debt instruments, and other kinds of credit experience an unexpected spike. Assets include business bonds and government bonds (such as US Treasuries) and student loans and mortgages.
The commodity bubbles occur when the price of traded commodities, or “hard” — that is, tangible — materials and resources, such as gold, oil, industrial metals, or agricultural products, increases.
Stock market and market bubbles can result in a broader economic bubble, in which a region’s or country’s economy expands at an alarming rate. Numerous historians believe the United States overheated in this manner during the 1920s, dubbed “The Roaring Twenties”—resulting in the 1929 Crash and the subsequent Great Depression.
A Bubble’s Five Stages
Hyman P. Minsky, an economist, was the first to understand the evolution of financial instability and its relationship to the economy. He described five stages in a typical credit cycle, one of the multiple periodic economic cycles, in his seminal work, Stabilising an Unstable Economy (1986).
Additionally, these steps define the fundamental shape of a bubble.
When investors get fascinated with a new paradigm, such as an innovative new technology or historically low-interest rates, a displacement occurs. The fall in the federal funds rate from 6.5 per cent in July 2000 to 1.2 per cent in June 2003.2 is a classic example of displacement. The interest rate on 30-year fixed-rate mortgages decreased 2.5 percentage points during these three years to a then-historic low of 5.23 per cent, laying the groundwork for the last housing boom.
Prices initially rise slowly following a displacement but then accelerate as more participants enter the market, laying the groundwork for the boom period. During this stage, the subject asset receives considerable media publicity. Fear of missing out on a once-in-a-generation chance fuels additional speculation, attracting a rising number of investors and traders.
Caution is thrown to the wind during this phase as asset prices surge. Valuations soar to extraordinary levels during this phase, as new valuation measurements and metrics are claimed to justify the relentless climb, and the “greater fool” theory—the belief that regardless of how prices move, there will always be a market of buyers willing to pay more—is applied universally.
For instance, in 1989, during the height of Japan’s real estate bubble, prime office space in Tokyo sold for up to $139,000 a square foot.
Similarly, during the peak of the Internet bubble in March 2000, the total value of all Nasdaq technology stocks was more significant than the GDP of most countries.
During this period, the smart money begins selling positions and taking profits, heeding warning signs that the bubble will collapse. However, predicting the precise time a bubble would burst can be difficult because, as economist John Maynard Keynes put it, “markets can remain irrational longer than you can be solvent.”
For example, in August 2007, the French bank BNP Paribas froze withdrawals from three investment funds with significant exposure to US subprime mortgages due to an inability to evaluate their holdings.
While this revelation alarmed initially financial markets, it was quickly forgotten as global share markets achieved record highs over the next few months. In retrospect, Paribas was correct, and this very insignificant occurrence served as a precursor to the stormy days to come.
A relatively minor incident can pierce a bubble, but once pricked, the bubble cannot inflate again. During the panic stage, asset prices reverse course and fall at the same rate they had risen. Faced with margin calls and collapsing asset values, investors and speculators increasingly seek to liquidate at any price. When supply exceeds demand, asset prices fall precipitously.
One of the most striking global financial market panic examples happened in October 2008, only weeks after Lehman declared bankruptcy. Fannie Mae, Freddie Mac, and AIG came dangerously close to collapsing is another example. That month, the S&P 500 fell over 17%, its ninth-worst monthly performance.
Tulipmania is the term used to characterise the first big financial bubble, which occurred in 17th-century Holland: tulip prices surged beyond rationality, then dropped as quickly as the flower’s petals.