Economic trends are dynamic and change continuously due to political, geographical, financial, and socio-economic factors. These changes often lead to the formation of economic bubbles.
An economic bubble is a situation where securities and assets are traded at values that are much higher than their intrinsic values.
What causes an economic bubble?
There is no particular reason for the formation of an economic bubble. Economists and analysts have different views on this matter. However, some situations that can lead to the formation of an economic bubble are:
- When the economy is in the boom phase. Where industries and companies prosper and grow. Which in turn results in higher salaries for employees. This increases the disposable income of the household. People start investing in various assets. As a result, the prices of different assets increases, leading to a bubble.
- As the economy expands, the number of liquid assets increases. As the lending rates fall, investors borrow money to invest in these assets. Hence, the demand for these assets increases. As a result, the prices of these assets start increasing steeply.
Stages of an economic bubble
A typical economic bubble has five stages. These stages are:
- Displacement – A displacement occurs when investors start focusing on a new trend or technology in the market. For example, if the lending rate on home loans decreases, a large number of consumers will start taking home loans. As a result, investors will start investing more in real estate. This can eventually increase property prices.
- Boom – As more investors are attracted to the trend, it gains momentum. Prices start to increase at a rapid pace.
- Euphoria – The prices of different assets skyrocket. But that does not dissuade investors. They keep paying higher prices for getting higher returns.
- Profit-taking – Cautious investors who are mindful of a possible ‘bubble burst’ start selling their assets to make profits.
- Panic – Finally, the bubble bursts and the prices start falling rapidly.
Types of bubbles
There are a large number of asset bubbles that can form in the market. But in general, they can be classified into four categories:
- Stock market bubble
When the market prices of equity stocks increase rapidly beyond their intrinsic value, a stock market bubble is formed.
- Credit bubble
Credit bubbles involve an increased demand for consumer loans, debt instruments like bonds, debentures, and other forms of credit. For example, if the lending rate decreases or debt instruments offer higher interest rates, it may give rise to a credit bubble.
- Commodity bubble
A commodity bubble is formed when the prices of commodities like oil, gold, and other metals significantly increase.
- Market bubble
Market bubbles involve the other sections of the economy. For example, if a bubble forms in the real estate industry, it will be known as a market bubble.
Economic bubble examples
Economic bubbles have happened before and are likely to happen again. ‘When’ of the economic bubble is not the worry but ‘how’ should be monitored. Like how investors should safeguard their assets or their purchasing power or build up sufficient reserves to meet the crisis.
Let’s understand the economic bubbles of the past and what we can learn.
The dot-com bubble in the United States
During the late 1990s, the usage of the internet remarkably increased. So, a large number of investors started investing in internet-based companies. As a result, the values of shares of these companies grew exponentially. However, as the market peaked, investors got wary and started selling their assets to make profits. The values of these shares started decreasing. This resulted in a bubble burst that significantly impacted the stock market. Many companies went bankrupt and were shut down.
US housing bubble
Since 2000, the US housing market has been marching towards a housing bubble that burst in 2007-08. It was known as the subprime lending crisis. It all started with the Fed Reserve bringing down the interest rates to rock bottom levels. While it was done with good intentions, the result was an upward spiral in home prices. As borrowers took advantage of the low-interest rate scenario, even those with poor credit history were able to borrow money and buy a house.
Banks sold them to investment banks as low-risk mortgaged-backed securities. When interest rates started to rise, borrowers felt the pinch and started to default on the mortgage payments. When banks tried to sell, the houses were worth a lot less than the amount it was purchased. And one lender after another filed for bankruptcy.
Another example is the Tulips bubble in the Netherlands. It was reported to have gone up to $50,000 per Tulip. It was later famously known as the Tulipmania.
You cannot identify economic bubbles in real-time. So, as an investor, you should be cautious while investing in an upward trend. If the prices are rising, check the fundamental values of assets before investing in them. See if the price you pay for one stock is worth the money.
If the cost of an asset exceeds its intrinsic value or worth, it is a sign of a bubble formation. You can invest in such assets to get maximum returns. But, try to cash in those investments whenever there is a sign of a bubble burst. Use financial ratios such as Price to equity ratio or price to book ratio to identify if the stock is highly-priced or undervalued.
Invest according to your risk appetite. And time your exit. Say for instance, if you had invested with an objective of making 50% or 80% of the profit from a stock, then exist once when a stock reaches that limit. Perhaps even partially exit.
There are a lot of people who have made substantial profits even during an economic bubble. Be smart. And thoroughly analyse the market situation before investing.
- Do economic bubbles form regularly?
No, economic bubbles do not form regularly. Economic bubbles form when there is an advent of a new trend that can attract investors.
- Are we in an economic bubble right now?
We cannot identify an economic bubble in real-time. So, the only thing we can do is identify the market signs to analyse the possibility of the formation of an economic bubble.