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.
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.