How to avoid or spot price bubbles and predict a market crash or bubble burst effectively.
What is a bubble?
A bubble i.e. economic, financial, investment, credit, speculative or asset bubbles can be defined as a situation where the price of an asset exceeds its real value.
During the duration of a bubble, the price for an asset class gets highly inflated. You would not find any resemblance of the authentic cost of an asset.
In this article, we aim to assist our readers to understand how to spot a bubble successfully and how to avoid investing in a bubble and ending up bankrupt.
Asset price bubbles or economic bubbles are always followed by a spectacular crash in the price of the securities in question. People think that high prices of assets would give high returns in the future and they invest in these assets classes.
A bubble is the best example which proves that the crowd is not always wise.
Bubbles usually have a catastrophic effect on the economy, and due to globalization, their effects are felt around the world. The damage depends on the economic sectors and the participants involved. They can be local or widespread.
- Must Read – Investing at a Young Age: The Pros and Cons
The burst of a bubble can lead to long-term stagnation of the economy of a country. The best example, for it is the 1980’s bubble in Japan.
The chemistry that leads to an economic bubble is a mystery to everyone. We can call an economic bubble as an abnormal rise in asset prize that exceeds the asset’s intrinsic value. The prices are not rational and are set due to high demand. But, sooner or later people come to their senses and it crashes, leaving many people in massive losses and failures of financial systems.
Economic bubbles can lead many economies to recession when the asset prices collapse. The US housing bubble is a good example.
Some types of bubbles are easy to spot than others; one good example is stock market bubbles. It is because traditional valuation metrics would easily find out any overvaluation.
Most bubbles are harder to detect, and the only way to identify them successfully is after a markets crash.
Many economists had argued on the presence of a housing bubble in the US in the year 2004 and 2005. But, no one could predict a bubble successfully. Predicting a bubble successfully can help in the next recession prediction.
Past Financial Bubbles in the World that Can Help You Understand the Concept of a Bubble
The US Housing Bubble
Traditionally it is observed that housing markets are always prone to bubbles. The US house prices doubled down at a staggering rate from the year 1996 to 2006. From the year 2002 to 2006, there was an enormous increase in real estate values.
In hindsight, experts now believe the US housing bubble was the result of the bursting of the NASDAQ bubble, which was the biggest bubble the world has ever seen. It made the investors believe that real estate is a safe investment.
After the collapse of the housing prices due to the housing bubble burst The United States experienced a subprime mortgage crisis which can be defined as a national banking emergency from 2007 to 2010.
This banking crisis led to the failure of big banks around the world and led the US and other European economies into a recession. Central banks had to come in and inject many international banks with liquid funds.
Subprime mortgages are a form of an earlier expansion of mortgage credit. It offers mortgages to risky borrowers who would have had difficulties in getting mortgages issued. These mortgages contributed and facilitated the rising real estate price trends.
Subprime mortgages are offered to borrowers with low credit rates. Historically such buyers found it difficult to secure loans unless protected by government insurance. High-risk mortgages were made available repackaging them into pools which were sold to potential investors.
Investors and big banks started heavily investing in the Private-label mortgage-backed securities (PMBS) that provided the primary funding for the subprime mortgages. These securities were viewed as safe because they were thought as low risk or people thought that other securities would have absorbed any losses.
When the high-risk borrowers failed at making loan payments, they either sold their homes for profits or borrowed more against very high market prices. When the housing market collapsed, borrowers started to default on the payment of their debts as the houses were worth less than the amount they borrowed. It discouraged the borrowers. The value of these mortgages fell rapidly.
Many banks who had heavily invested in subprime mortgages failed. This led to major bank failures in the US and other countries. The central banks had to bail out many banks that were considered too big to fail. Some banks have been entirely taken over by the government.
The central banks started liquidating bank assets and selling them for a lower value to settle the debt. As a response to this crisis, banks limited lending and this affected businesses.
The US housing bubble crash led many economies around the world to go into recession and real estate values to crash. It took a long time for the US economy to recover and they are still affected by it.
The Dutch Tulip Bubble
The Dutch Tulip Bubble is the best example to understand an irrational financial bubble. It is now the yardstick of measuring price bubbles.
The Tulip Mania which had gripped Holland in the 1630s is the earliest recorded bubble in history. Tulips were newly introduced to the Netherlands and were considered precious. It took seven years to grow these vibrantly colorful tulips.
Their prices soared to irrational levels, and growers started to pay insane amounts to acquire them. According to records, the prices of tulips were increased around twenty times by November 1636 and February 1637.
By May 1637, there was a 99% rise in the price of tulips. As it happens in every bubble economy, Tulip Mania consumed the entire Dutch population. Everyone was in the race of securing the highest amount of tulips for themselves.
At the peak of the bubble, tulips were worth more than luxury houses. Like all bubbles as the availability of tulips increased its price crashed making many people bankrupt and shaking the economy.
Let Us Look at a Few Indicators of a Financial or Investment Bubble
One important economic Indicators of a “bubble” is that the prices rise faster because of the growing demand. The interest rates are usually enormously high in a bubble economy.
By looking at the trends, in a bubble economy, you cannot understand where the market is heading. Unusual changes in a single measure are observed, or relationships among measures relative to their historical levels are unusual.
During the housing bubble the real estate prices were unusually high when compared to relative income. During the Tulip Mania the Tulip prices exceeded the average daily wages of an average Dutch man.
During a bubble, asset price in question first increases slowly then following a displacement, it again gains momentum as more and more investors enter the market, which ultimately leads to the boom phase.
People have a positive view on investing in the asset classes in question. Everyone you meet gives you pieces of advice on investing in the particular stock market investment. Some people go into panic mode on missing out on an opportunity of a lifetime.
Everyone, you know now claims that someone they know has made around 50% or 100% profits from this trend. More and more people move in to invest in these assets in the hope of becoming a millionaire.
Investors start taking loans to invest in the stock market. It is one of the most alarming signs of a bubble. Investors go on local media platforms and talk of new magical paradigms that are being hatched without even considering the prices in the past. Caution is thrown to the wind, as the asset prices skyrocket during this phase.
This was the case before the US housing market collapse when people lost all rationality of real estate price trends in the past as they tried to invest in real estates at an unusually high price.
Most news organizations bring experts who advise you to invest in these asset classes and call you dumb for not ceasing the opportunity. Experts ask you to open your eyes and accept these false values assigned to these assets.
Everyone is an investment expert, and you are constantly bombarded with articles and programs on how someone became a millionaire by selling a particular asset class which was previously worth nothing.
People Move to Sales
During the era of the dot com bubble many people left decent jobs and well-paying careers to become stock brokers. Similarly, the real estate bubble caused many people to become retailers or real estate agents.
During the period of bubbles, the hottest job becomes selling of assets which are desired by everyone. More and more people leave their careers to get a sales job.
Compare with Previous Market Prices
If the recent prices have escalated upward sharply, there is an excellent chance that it is a financial bubble, and it may not last. Prices increase slowly then they reach a value insanely high which cannot be justified rationally.
But, investors and people usually ignore these red flags as they only care about profits or they want to make the most of the situation. But, prices can rise for other reason too, for example, oil prices and coal prices can rise if there is an oil or coal shortage. A lower interest rate is the biggest red flag, it promotes lending and borrowing.
According to Minsky, there are five stages of a bubble which are displacement, boom, euphoria, profit taking and panic. In hindsight, this technique is used to identify a bubble when the entire event is over.
Minsky and a number of other experts are of the opinion that in free-market speculative bubbles in some asset is inevitable.
To avoid these, many experts believe there should be some restrictions imposed by the government on financial institutions to save customer deposits. However, it may not be effective in the long run as too much control may kill the economy.
If you identify the above signs, you should be alarmed. But, a financial bubble can also make you a lot of money, if you can buy these assets and sell them at the peak of the bubble at an insane cost. We, however, do not advise the readers to take such a risk.