What is an economic bubble?

Posted on Monday, July 15th, 2019 MarketBeat Staff

Summary - In 1996, then-Federal Reserve Chairman Alan Greenspan uttered the words "irrational exuberance" into the American investing vocabulary. Although Greenspan was only answering a question (i.e. how does the Central Bank know when an asset is overvalued?), Greenspan’s words immediately sparked a sell-off on Wall Street as investors feared that the Fed Chairman was signaling the Fed would raise interest rates and choke off a stock market rally.

Of course, it would only be a few years before investors discovered what the output of irrational exuberance brings – an economic bubble. In investing terms, an economic bubble requires two things. First, a rapid rise in the price of an asset that is far beyond its intrinsic value. Second, investors are not buying the asset for the purpose of holding it, but rather because they have confidence they can find a seller who will pay an even higher price than they did. Of course, the bubbles burst when the asset price reaches a tipping point. When this occurs, institutional investors can no longer ignore the risk and begin to sell. At this point, the price of the asset declines quickly leading to panic selling as investors “rush for the exits” and will sell at any price.

The two most notable economic bubbles in recent memory were the dot-com bubble of 2000 and the housing bubble that occurred between 2006 and 2008. Both situations have led to significant regulations for Wall Street as well as in the monetary policy of the United States. Although some economists are speculating that bitcoin and other cryptocurrencies are the beginning of another economic bubble, other economists are pointing out the very fact that bitcoin is not a fiat currency makes it hard to tell if this is the beginning of a bubble or something entirely different.

Introduction

"Don't burst my bubble", is a phrase we often say when someone is advising us to exercise caution over plans we have made. There are times when we want to believe in something and we let feelings get in the way of our better judgment. Sometimes, our common sense kicks in before we suffer the consequences. Sometimes, however, we're not so fortunate.  Investors are familiar with economic bubbles that occur when the price of a particular asset, or asset class, experiences price movement that is inconsistent with the intrinsic value of the asset. In this article, we'll explore economic bubbles in detail. In addition to defining what an economic bubble is, we'll review the theory behind it and also take a look at the five distinct stages of every economic bubble. We'll close the article by asking the question of whether cryptocurrency and particularly bitcoin, maybe the next economic bubble.

What is an economic bubble?

An economic bubble is a condition caused when an asset rises in value based on investor sentiment that is not supported by fundamental or technical analysis of the stock. Another way to say this is that an economic bubble is present when an asset far exceeds its intrinsic value by any conventional measure. The premise of a bubble is that investors are buying an asset for the purpose of selling it to another investor for a higher price. As long as there are buyers, the bubble can keep getting bigger. The end of a bubble occurs when buyers stop buying and the asset price sharply corrects.

Economic bubbles and the “Greater Fool” theory

The Greater Fool theory speculates that many investors enter a bubble in its early stages not because they believe the asset has long-term value, but because they believe that they can find a buyer who will pay them more than they paid for it (i.e. the greater fool). The greater fool theory ends when the market runs out of fools. At that point, like a roller coaster that reaches the top of a steep hill, there’s only one way for prices to go – down. Let’s take a look at how this theory played out during the two most recent economic bubbles, the dot-com bubble of the late 1990s and early 2000s and the housing bubble of 2007-2008.

  • In the case of the dot-com bubble, it was not that investors believed in the product or company. In fact, many investors violated a cardinal rule of investing. They didn’t understand a company’s business plan (if the company even had one). Rather, they were confident that they could find a buyer with the fear of missing out (FOMO) who would pay them more than they paid for the asset.
  • In the case of the housing bubble, sub-prime lenders issued mortgages to people who would not otherwise qualify because the lenders had no intention of holding on to the mortgage. They were looking to sell the mortgage quickly, usually within 6 months. When buyers defaulted, as we all know now that they frequently did, the original lender was not hurt. They had successfully shifted the risk premium to another lender.

Every bubble has predictable stages

Although no two bubbles are exactly alike, they all follow a predictable pattern that occurs in five stages.

  • Stage 1: Investors become aware of a movement– This is called displacement. In this stage, investors become aware of a new product or new technology. In other cases, such as the housing bubble, the displacement came from historically low-interest rates that made it more tempting for consumers to borrow money.

  • Stage 2: Prices increase along with buying activity– At first glance, a bubble is not easy to see. After all, many stock analysts have made a fortune by identifying small-cap companies that are ready to grow. For a bubble to work, however, the asset prices continue to rise regardless of any warning signs such as a new technology that has no practical application, new products that have no market, or geopolitical events that signal an imminent change in economic policy. As the prices rise, investors who are not in the market develop the fear of missing out (FOMO) which spurs even more buying.

  • Stage 3: Prices become decoupled from intrinsic value– At this point, any investors who haven’t gotten in are rushing to get in regardless of what the fundamentals dictate.

  • Stage 4: The smart money begins to take profits – Just as it’s not easy to see when a bubble starts, it can be difficult to predict exactly when a bubble will burst. However, at a certain point, institutional investors will no longer ignore the warning signs and will engage in profit-taking, thus initiating a sell-off.

  • Stage 5: As asset prices tumble, there is a race to the exit– Just as an asset bubble blows up because prices become decoupled from fundamentals when a bubble bursts the sell-off is usually just as quick and sometimes just as irrational. The same investors who jumped in at any price are now jumping out at any price. As sellers outnumber buyers, the asset price plummets.

Are we seeing the beginning of a new bubble?

Cryptocurrency, and in particular bitcoin, are generating a lot of discussion in terms of being our country’s next asset bubble. One of the key reasons for this speculation is that bitcoin’s price has risen, seemingly based purely on investor sentiment. However, a characteristic of cryptocurrencies is that they are not the same as a fiat currency such as the dollar and euro. As such, they are more like gold. Volume and scarcity is another reason to question whether bitcoin is really a bubble. Unlike fiat currencies, which are governed by a central bank that can “print money”, there will be a fixed number of bitcoins to be “mined”. This means that the currency will be more likely to hold, if not increase, their value.

The final word on economic bubbles

Economic bubbles are events that, like a bull market or bear market, are tough to detect until they already exist. Like many things, economic bubbles are exciting until they burst. In the late 1990s, there were many investors questioning the valuation – if not the business model – of many internet start-up companies, even as financial publications were touting "Nasdaq 10,000". Between 2006 and 2008, housing prices were rising to unprecedented, and many said unsustainable, levels as borrowers with incomes that would have never qualified for a mortgage before were approved as fly-by-night lenders passed off the risk from qualifying these sub-prime mortgages. In both cases, the fallout from these bubbles bursting has created increased regulation and changes in monetary policy – including the role of the Federal Reserve in "fine-tuning" the equities market. Yet, for all of the cynicism being directed at Wall Street, the roots of an economic bubble are firmly rooted on Main Street where investors do what they always do – they dream of finding their "next Google". Unfortunately, all too often, their belief in what an asset "should be" gets in the way of what the asset actually is doing. This contradiction has occurred before and will certainly happen again. The best advice remains, if an investment looks too good to be true, it probably is.

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