What is a Bubble
An asset bubble is a situation where the price of an asset rises significantly over a short period of time. This rapid increase in the price of the asset is usually followed by a rapid drop in the price of the asset in a short time frame which often known as a crash or the bubble bursting.
Now there are some relative terms here such as ‘significant’ and ‘short’; how do we know what a short period of time is and what is a significant rise in price? One of the tellings signs of a Bubble is that the price of this inflated asset is often not supported by the value of the product.
As interest grows in an asset class and as more people purchase the price goes up and this is not unexpected. During a bubble however, there is a significant disparity between the price of the asset and the value of the asset.
It is not easy to determine the value of an asset and that is beyond the scope of this article. It is also worth noting these market inefficiencies give rise to opportunities for Active Investors to explore.
One of the earliest examples of a bubble was the tulip mania in the 1600s when people bought tulips with the belief they could sell it at a higher price in future to someone else. Question: how much was a Tulip worth?
What does Bubble mean
In market terms a bubble or more accurately asset bubble refers to a rapid increase in the price of that asset class in a short period of time. So when we hear people say there is a real estate bubble or stock bubble, they are referring to the rapid increase of the price of real estate or the stock market index in that specific region.
It also means investors are overly optimistic about the price of an asset and this can be seen by their buying of the asset beyond the real value of the asset.
What Causes a Stock Market Bubble
There are different things that can cause a stock market bubble and from what we have seen in the past, they can be caused by the behaviour of the investors and speculators depending the economic conditions. Here we examine some of examples of recent bubbles.
Dot-Com Bubble
Taking a look at the dot-com bubble investors poured money into companies many of which barely had a track record of profits and expected the prices to continue to rise. Whilst there are other factors to consider, it is clear that the irrational exuberance was a major factor in the cause of the dot-com bubble.
The Great Financial Crisis
During the real estate bubble in 2005 that led to the credit crisis in 2008, credit default swaps were used to as a way to insure mortgage backed securities which were traded on the market.
Since it was assumed these MBS (Mortgage Backed Securities) were secure because the mortgages they were tracking were mortgages where the people were deemed to be low risk in terms of defaulting the mortgage, these instruments were inherently safe to trade and fund managers drove up demand for these asset classes.
A low interest environment also meant people were taking on more debt, buying second, third and fourth homes on interest only repayments. Once the Fed raised interest rates, people who were barely keeping up with the mortgages defaulted on them. The MBS that were packed with these sub-prime mortgages were worthless because their value to an extent as based on the premise that the owners of the mortgage will keep paying.
Easy access to money and how investors reacted to this by taking on too much debt are the main causes of this. The Hedge fund managers and other investment managers that were selling these products also contributed to the hysteria.
Bitcoin and Cryptocurrencies
In 2017, despite Bitcoin being in existence for some time leading to this, there was renewed interest in Bitcoin to put it mildly. As various governments and financial institutions recognised Bitcoin as a commodity or asset class, investor poured more money into Bitcoin.
At the beginning of 2017 the market cap for Bitcoin was $16 billion and by the end of the year it was a whooping $229 billion. The interest in Bitcoin and Cryptocurrencies around this time was something for investors to be wary of and in many cases, the positions taken in Bitcoin were speculative.
Main street got excited by the prospects of Bitcoin being widely accepted by some countries like Japan, financial institutions considered Bitcoin as an asset class and put money into it hoping the price will continue to rise.
The way investors interpret the economic situation to an extent determines how they behave and in an environment where money is easy to borrow or rates are low, investors are likely to take more risks.
What Causes the Bubble to Pop
Well the party cannot last forever right? And what goes up must come down as the saying goes. To understand what causes the bubble to pop, let us take a closer look at what leads to the bubble and what they different stages are.
Charles Kindleberger (cool name by the way) in this book titled Maniacs, Panics and Crashes: A History of Financial Crises outlined the five different phases of as asset bubble which has been summarised in our own words. Here is a link to reviews on this book.
Stage One – Displacement
This is the stage where investors notice something new like Bitcoin, or Tulips or a particular asset class.
Depending on the nature of the speculative boom, it could also be economic conditions such as low interest rates, government assistance cheques to help furloughed workers. Think of this stage as a shock to the system or something new that catches the investors eyes.
Stage Two – Boom
At this stage, the money is coming in as investors start purchasing more of this asset. Their biases kick in and FOMO (Fear Of Missing Out) is driving more investors from Wallstreet to Mainstreet to put their money in this asset.
Stage Three – Euphoria
We are approaching fever pitch at this point as every new article seems to be talking about this asset. Everyone one from accountants to zookeepers are looking to get in on the action and FOMO has now been combined with YOLO (You Only Live Once).
The underlying asset is hitting new highs on a daily, weekly or even monthly basis further driving the prices higher.
Stage Four – Cataclysm
When it gets to this point, some investors usually the ones who got in early are ready to exit. They start cashing out, closing their positions and selling the asset and the effect on the price of this asset that has been hitting new highs is now evident.
New potential investors at this may wonder at the lack of not so positive headlines regarding this asset class. In some situations like real estate, the initial investors who took on debt to fuel their exuberant spending now become desperate to sell and enough of them selling can have an effect on the prices.
Stage Five – Pandemonium
At this stage, the fan has been struck with proverbial manure and everyone is heading for the exit. The price rapidly drops are there are more sellers than buyers and investors are eager to exit their positions quickly whilst demand diminishes for the asset.
The bubble bursts when a large number of investors start selling the underlying asset class in a short period of time. This could be due to a change in the economy such as interest rates going high or some news or event that causes people to view the asset in a different light.
What are the Consequences of Stock Market Bubbles
Looking at the recent market bubbles, we know there are consequences for the investors who invested in the asset class, for the companies where relevant and possibly for the economy as a whole.
During the dot-com bubble a lot of those companies that had no earnings but had increasing market capitalisation as investors poured money into them went bust when the bubble popped. The price of these companies at its peak could not be backed up with the real value of the company.
Although many technology and internet companies were impacted negatively, some of them survived this period and for the wider economy there was some concern however the main impact was felt by the people who put their money in internet companies that failed.
Moving forward to the housing bubble and the financial crisis, we can see a different type of impact and one that is arguably deeper in terms of economic damage. Unlike the dot-com bubble, in the housing bubble people lost their homes and this had a direct impact on other aspects of their lives.
Interest rates were low and many investors purchased new homes, some entirely financed with debt and placed these home on interest only mortgages or adjustable rate mortgages.
Whilst rates were low, many could barely repay these mortgages and on Wallstreet these mortgages were packaged, sliced and sold to investors. As interest rates were raised, many of the multiple home buyers who had sub-prime mortgages (basically a higher possibility of default) defaulted on their payments.
The Credit Default Obligations on these financial instruments could not be fulfilled as many people defaulted on their mortgages so Uncle Sam had to step in to bailout institutions. Banks were stricter with their lending, people lost their investment homes and in some cases their own homes, job cuts were common place and the overall standard of living for many people dropped.
This is just a quick summary to highlight the impact of this housing bubble and financial crisis brought on by the credit crunch. The economy, jobs and housing were impacted. Banks failed and some countries came close to collapse due to civil unrest and a lack of trust in the financial system.
The Bitcoin bubble in 2017 was significant but not as impactful to the wider economy and part of the reason was that Bitcoin and other Cryptocurrencies were not yet mainstream in such a way that it would affect the wider financial system.
Many people at that point considered it to be more of a speculative tool and treated it as such so when it failed, the impact was within a small niche of everyday society.
How to Protect Yourself
You should read our article on how to survive a recession because it covers important points and like we have seen in the past, a bubble can lead to a crash and possibly a recession.
It is difficult to know there is a bubble due to human nature and the lack of relevant information however is important to recognise when the market or an asset is entering bubble territory.
Understand the Asset and Manage Risk
It is important that you learn how to determine the value if a company or an underlying asset and if you choose to go with the market, you need to manage risk. Fundamental Analysis can help with this as key ratios are examined among other things to determine the value of the asst.
Diversify your Portfolio
Properly diversifying your portfolio will minimise the risk of being wiped out completely. Investing in different asset classes, sectors or industries will help in the event of a bubble in one.
Hedge
You suspect the market may fall although timing it is impossible, you need to hedge or have a plan to hedge your position so in the event of a rapid decline in prices or lack of liquidity, you can reduce your potential loss.
Final Note
A market bubble is characterised by a rapid increase in the price of an asset in a short period of time and this can range from weeks to months. There are five stages in a bubble and one stage does not necessarily lead to the other however many bubbles have followed this pattern.
Bubbles are can be caused by different factors and depending on why investors are pouring money into the asset. When the bubble pops as they all do, the impact could be widespread as we saw in the housing bubble and credit crunch or just within the asset class as we saw with the 2017 Bitcoin bubble.
It is impossible to time the market and to know when the bubble will pop that is why it is necessary to improve your financial knowledge, learn how to analyse an asset class and if you choose to participate in an asset in a bubble stage, do not over expose yourself to a position, diversify your portfolio and hedge your bets.
