Understanding Financial Bubbles
With the number of Google searches for ‘stock market bubble’ at an all-time high in January 2021, financial bubbles are clearly at the forefront of the minds of investors. (1) However, the complex nature of financial bubbles makes differentiating them from just a bullish market an arduous task. This article looks more deeply into financial bubbles, defining what they are and how they are formed as well as investigating methods of prediction.
Defining a Financial Bubble is not an easy task and has produced lots of debate about definition and causation amongst modern economists. That said, a financial bubble can be defined as when assets (which can vary from commodities to housing to stocks) significantly increase in value over a short period of time. These bubbles conclude with the collapse of the price of that asset, leading to drastic losses for investors who got in too late.
Reasoning behind the initial, unpredicted increase ultimately comes down to a rise in demand for those assets. An excellent way to assess how bubbles can be formed is to look at the history of similar investments and see what caused some of the most notable financial bubbles in history.
The Dutch Tulip Mania is commonly considered the first ever financial bubble. With an affluent and growing middle class, rare tulips were used as a symbol of wealth in the 1930s in the Netherlands. (2) As these tulips grew in popularity, their price corresponded. Whilst prices rose, so did the interest as much of the market began to look at the potential profit from buying tulips, to sell them at a premium at a later date. Some tulips in the period experienced as high as a 12-fold increase in price whilst others some were even worth as much as luxury real estate. (3) However, all this ended very abruptly in early February 1637, when the incoming Black Plague combined with existing fears about the market being unsustainable caused a dramatic fall in demand. Resultantly, the price of tulips fell to virtually nothing. (4) Although it did not massively impact the Dutch economy, this shows that market speculation can have an effect on market behaviour and thus can be a cause of financial bubbles.
With access to the internet growing exponentially in the 1990s, investors put lots of their money into internet-based companies with the expectation of extremely high returns in the coming years. The 1990s boasted over 5,700 IPOs, with many companies choosing to go public in order to try and get the benefit of the speculated rewards of the internet. (5) Whilst more and more companies went public, the heavily-technology-based Nasdaq grew by over 400% from 1995 to 2000, as seen on Figure 1. (6)
What are they?
Defining a Financial Bubble is not an easy task and has produced lots of debate about definition and causation amongst modern economists. That said, a financial bubble can be defined as when assets (which can vary from commodities to housing to stocks) significantly increase in value over a short period of time. These bubbles conclude with the collapse of the price of that asset, leading to drastic losses for investors who got in too late.
Reasoning behind the initial, unpredicted increase ultimately comes down to a rise in demand for those assets. An excellent way to assess how bubbles can be formed is to look at the history of similar investments and see what caused some of the most notable financial bubbles in history.
Tulip Mania: 1636-1637
The Dutch Tulip Mania is commonly considered the first ever financial bubble. With an affluent and growing middle class, rare tulips were used as a symbol of wealth in the 1930s in the Netherlands. (2) As these tulips grew in popularity, their price corresponded. Whilst prices rose, so did the interest as much of the market began to look at the potential profit from buying tulips, to sell them at a premium at a later date. Some tulips in the period experienced as high as a 12-fold increase in price whilst others some were even worth as much as luxury real estate. (3) However, all this ended very abruptly in early February 1637, when the incoming Black Plague combined with existing fears about the market being unsustainable caused a dramatic fall in demand. Resultantly, the price of tulips fell to virtually nothing. (4) Although it did not massively impact the Dutch economy, this shows that market speculation can have an effect on market behaviour and thus can be a cause of financial bubbles.
The Dot-Com Bubble: 1997-2001
With access to the internet growing exponentially in the 1990s, investors put lots of their money into internet-based companies with the expectation of extremely high returns in the coming years. The 1990s boasted over 5,700 IPOs, with many companies choosing to go public in order to try and get the benefit of the speculated rewards of the internet. (5) Whilst more and more companies went public, the heavily-technology-based Nasdaq grew by over 400% from 1995 to 2000, as seen on Figure 1. (6)
However, all the hype around internet stocks would begin to reduce from 2000. The US interest rate increased in February 2000 which sparked fear of pricier funding for companies. This was timed very closely with the Japanese economy entering into a recession in March 2000 which together triggered the mass selling of stocks, particularly those pertaining to technology. (8) This sell off was intensified when Barron’s (a popular financial magazine) featured a study of the obscene cash burning forgoing at internet-based companies. (9) Over the next two years, the Nasdaq fell by 78% compared to its peak, as investor confidence plummeted, and entire fortunes were lost. (10) The aptly named dot-com bubble is another example of how speculative activity even based on little information can cause the price of an asset (in this case the equity of internet-based companies) to fluctuate.
The US housing market bubble is one that people often immediately think of when financial or ‘market’ bubbles are mentioned. An increase in lending from financial institutions throughout the early 2000s as a result of the growth in mortgage backed securities led to big rises in the prices of real estate. Lots of inaccurate information along with inadequate information checks exposed both institutions and customers to unnecessary risk. As the desire to lend was seemingly exponential, mortgages began to be awarded to individuals who had no realistic ability or likelihood to keep up with the required payments. (11) As mortgage defaults increased, so did the supply of housing on the market which led to huge decreases in real estate prices. Throughout 2007 and 2008, housing prices would decrease by a whopping 18% and with that, the housing bubble was over. (12)The US housing bubble is a different example, showing more of an institutionally induced bubble which ‘popped’ as a consequence of the excess lending.
As world renowned investor Warren Buffet put it: ‘A pin lies in wait for every bubble’. (13) This comment makes a point about market bubbles with the implication that, at one point or another, all bubbles have to pop. A detection method for financial bubbles is highly sought after as a result of the harsh consequences for investors and negative externalities for the rest of the economy. However, it is a very difficult task.
One of the biggest issues in predicting market bubbles is identifying the distinction between them and a bullish market sentiment. Just because the price of a certain asset is rising significantly, it does not necessarily indicate the beginning of the formation of a bubble. It is possible that a certain industry is simply performing excellently and so the market reflects that. The question here is, as asset prices increase, how high is too high?
There is not a simple answer to this question that everyone can agree on, but some attempts have been made to find a solution. Some believe that the CAPE index (Cyclically Adjusted Price Earnings) could be used. This compares the adjusted price of an asset to its earnings (e.g. the price of a stock would be compared to the present value of the dividends earned by owning that stock). This index is then used to try and identify ‘explosive behaviour’. (14)
Whilst all may seem well and good, the interpretation of this information is the crux of the matter. Though it can potentially be a useful metric, it must not be forgotten that there can be numerous other explanatory factors (e.g interest rates) which can influence market prices independently of financial bubbles. Thus, it is important to be careful and thorough when trying to interpret such a model.
To summarise this article, it is clear that financial bubbles are far from straightforward. Speculation and a kind of fear of missing out leads investors (both retail and commercial) to pump funding into assets that then soon become overvalued. When confidence in these assets falls, the price follows, leading to the ‘popping’ of the bubble. Whilst there are many who have attempted, and still are attempting, to predict the formation of market bubbles, a universal method has not been found. As a result, working out the difference between a strong bull market and a market bubble will continue to be a key challenge for investors in modern finance.
US Housing Bubble: 2006-2008
The US housing market bubble is one that people often immediately think of when financial or ‘market’ bubbles are mentioned. An increase in lending from financial institutions throughout the early 2000s as a result of the growth in mortgage backed securities led to big rises in the prices of real estate. Lots of inaccurate information along with inadequate information checks exposed both institutions and customers to unnecessary risk. As the desire to lend was seemingly exponential, mortgages began to be awarded to individuals who had no realistic ability or likelihood to keep up with the required payments. (11) As mortgage defaults increased, so did the supply of housing on the market which led to huge decreases in real estate prices. Throughout 2007 and 2008, housing prices would decrease by a whopping 18% and with that, the housing bubble was over. (12)The US housing bubble is a different example, showing more of an institutionally induced bubble which ‘popped’ as a consequence of the excess lending.
Predicting a bubble
As world renowned investor Warren Buffet put it: ‘A pin lies in wait for every bubble’. (13) This comment makes a point about market bubbles with the implication that, at one point or another, all bubbles have to pop. A detection method for financial bubbles is highly sought after as a result of the harsh consequences for investors and negative externalities for the rest of the economy. However, it is a very difficult task.
One of the biggest issues in predicting market bubbles is identifying the distinction between them and a bullish market sentiment. Just because the price of a certain asset is rising significantly, it does not necessarily indicate the beginning of the formation of a bubble. It is possible that a certain industry is simply performing excellently and so the market reflects that. The question here is, as asset prices increase, how high is too high?
There is not a simple answer to this question that everyone can agree on, but some attempts have been made to find a solution. Some believe that the CAPE index (Cyclically Adjusted Price Earnings) could be used. This compares the adjusted price of an asset to its earnings (e.g. the price of a stock would be compared to the present value of the dividends earned by owning that stock). This index is then used to try and identify ‘explosive behaviour’. (14)
Whilst all may seem well and good, the interpretation of this information is the crux of the matter. Though it can potentially be a useful metric, it must not be forgotten that there can be numerous other explanatory factors (e.g interest rates) which can influence market prices independently of financial bubbles. Thus, it is important to be careful and thorough when trying to interpret such a model.
To summarise this article, it is clear that financial bubbles are far from straightforward. Speculation and a kind of fear of missing out leads investors (both retail and commercial) to pump funding into assets that then soon become overvalued. When confidence in these assets falls, the price follows, leading to the ‘popping’ of the bubble. Whilst there are many who have attempted, and still are attempting, to predict the formation of market bubbles, a universal method has not been found. As a result, working out the difference between a strong bull market and a market bubble will continue to be a key challenge for investors in modern finance.
