Understanding Asset Bubbles and Their Various Stages

There is a saying: no risk, no reward. Every investment or asset comes with a risk and the level of risk varies depending on the type. With every asset, there is a possibility of asset bubble. Bubble can arise in any commodity that is being traded or financial instrument.

Bubble, a short name for asset price bubble, financial bubble or speculative bubble, can be best described as a quick rise in the price of assets such as housing and equities over a short period, followed by a sudden or a significant contraction in prices.

Why Do Bubbles Arise and Burst?

The over-inflated price of an asset occurs when large number of investors flock to a particular asset class without taking into consideration the asset’s intrinsic value (also called fundamental value, which is the net present value of all expected future cash flows). As the price of assets rises, it attracts the interest of investors, who want to quickly become rich and plan to sell these assets to the next investor at an inflated price. However, when there are no more investors willing to pay the over-inflated price, the bubble either bursts dramatically or deflate slowly.

What Are The Stages Of A Bubble?

Bubbles unfold in several stages. Let us have a look at the various stages of a bubble.

Displacement: This is the first phase of a bubble. Displacement is a kind of a shock to the system due to the launch of a new technology, a financial innovation, a change in monetary policy, a political development, among others. This results in an emerging and profitable opportunity in at least one asset class.

In this stage, the asset is known to only few investors, who have better access to information, thus they quietly and cautiously make their investments in the asset class. Moreover, these investors are more capable of understanding the economic context on a wide level that might result in an asset inflation. Prices of that asset start rising on a gradual pace and often remain unnoticed by the general population.

Awareness: In this phase, the market trends higher with large amounts of capital flood, as people with large sum of money get to know about the asset and the potential it holds. Mutual funds, hedge funds, pension funds and other institutional investors join in. Moreover, credit institutions become more willing to make riskier loans, as borrowers become more willing to take on debt. A small number of investors also prefer to selloff in this phase, as they want to cash in their first profits.

During this phase, the media picks up the story. Eventually demand for the asset exceeds its supply, leading to a spike in prices.

Euphoria: During this phase, enthusiasm in the asset gets out of the hand, as the public jumps in for this once in a life opportunity. As a result, valuation of the asset reaches extreme levels, hitting new highs. Optimistic investors keep on betting on the asset with expectations about future appreciation, factoring in ever-increasing underlying asset prices.

The higher the price, floods of money keep coming in; many investors become delusional that the asset price will keep on increasing forever. Several smart institutional investors, at this stage, quietly move out of the market and sell their assets to make profits. However, several others keep on jumping in without any knowledge related to the market or its dynamic or fundamentals, as greed sets in.

Blow Off: Due to an event like a piece of news, a change in government policy or a bankruptcy, the price gains stall. As pessimistic stories gain traction, there is a decline in investor confidence and more selling happens. Buyers who financed their purchases with borrowed money get distressed. Panic selling leads to a huge decline in the asset price. The bubble pops, as prices crash and sometimes decline even below the pre-levels of the bubble.

In some cases, the panic sets in immediately; however, sometimes it takes a few months for panic to set in. A lot of people lose money, when the bubble bursts. Spotting a bubble is almost impossible; however, having knowledge regarding the steps involved in bubble formation might help investors to avoid their participation.

Famous Bubbles in the History

Bubbles are nothing new. They occurred throughout the history in several countries as well as asset markets. Let us have a look at some of the famous bubbles.

Tulip Mania: This is the first known bubble in the history. Back in 1600s, a botanist in Holland started planting tulips. The beauty of the flowers began to attract several others, and as a result several others began planting tulips.

Tulips became trendy and rich people started offering crazy prices for the bulbs. Soon due to excessive speculation, price of tulips, which had become a coveted luxury item, grew ten times of the annual income of a skilled craftsman. Soon there were only sellers of tulips and no buyers. The prices eventually fell, leaving many tulip holders bankrupt and nearly collapsing the economy of Holland.

Dot Com Bubble: Also known as Tech Bubble or Internet Bubble, this bubble occurred during early 2000s. The use and adoption of internet grew to extreme levels during late 1990s. Investors started throwing money at any internet-based company without considering whether the entity holds any potential.

In 1999, the bubble reached its peak value, with dotcoms holding crazy-level valuations. However, by 2001, internet companies lost nearly two thirds of their value. The bursting of the bubble took down several start-ups, as either their proposed businesses proved to be unprofitable or investors cut off their funding. Though not all the companies were failures; some of the entities like today’s internet giants Amazon and Google survived the dot-com bubble.

Housing/Financial Crisis-2008: Real estate has always been considered as one of the safest investments. However, this myth burst after the 2008 housing crisis. 1940 onwards, the United States real estate sector enjoyed growth every single year, with real estate prices soaring high, until 2008 when the housing bubble finally burst.

In early 2000s, mortgage interest rates were low, consequently consumers opted for large loans. Moreover, banks gave mortgages to even those who didn’t qualify for a mortgage due to either low income or a low credit score, believing that they can get their money back as well as earn a profit by selling the property. Investment banks further expanded the process of securitization of subprime mortgages into MBS and CDOs and repackaged debt into security offerings based on tranches.

Once the property bubble burst, several financial institutions across the globe were hit hard, as people who were unable to repay their mortgages started to default. Some of the world’s largest financial institutions and investment experienced major liquidity issues, owing to which the global economy almost collapsed.

Some of the other famous bubbles are British Railway Mania Bubble in 1840s, Wall Street Crash in 1929, and Japan's Real Estate and Stock Market Bubble in 1980s.

What is Bubble Burst?

All bubbles burst eventually, as this is their nature. A small bubble, which is local, has a low impact, while a large bubble results in huge destruction with interwoven financial, banking and economic aspects. Bubble burst is the point, where the prices of assets like real estate, stocks, bonds or commodities, fall at such a level that investors lose a lot of money. Several companies, at times, go bankrupt, while households lose money and jobs evaporate. Banks and other credit institutions get impacted, as they fail to repay the amount borrowed. All these painful consequences have a major impact on an economy.

What Can Policy Do About Bubbles?

The responsibility of a central bank is to deliver price, economic and financial system stability in the economy. Bubbles are a threat to the major goals of central banks, who are also aware of the damage that a bubble pose to the macroeconomic and financial stability of an economy.

Whether central banks need to take any action against spike in asset prices is among the most discussed issues. Several market players are of the view that the central banks are required to pay attention to any fluctuations in asset prices in order to avoid the accumulation of bubbles. While several others believe that they action should be to some extent to prevent any impacts on the expected inflation.

Central banks need to look for policies that temper the borrowing level, as sometimes situation gets worse when banks keep on borrowing money without considering the aftereffects. The only way to respond to asset price bubbles is through monetary policy tightening, which can reduce the impact of a bubble to some extent, if policymakers seek to keep the economic and financial system stabilised.

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