Bubble

What Is a Market Bubble?

The familiar adage goes "you never know you're in a bubble until it bursts," and that is especially true in the stock market. A bubble is defined as a period when prices rise rapidly, outpacing the true worth, or intrinsic value, of an asset, market sector, or an entire industry, like real estate.
In the event that you've ever watched a child blowing soap bubbles, you know how fragile they are. Made from the thinnest film of soapy water, they're filled with only air, thus any change or sudden movement, from a whirlwind to an inquisitive touch, will cause them to pop.
Market bubbles can take years to develop, however while there are a variety of factors behind their formation, they all share one thing in common: they burst, usually quickly, and the consequences can leave a devastating global impact.

What Causes a Market Bubble?

In any case, for what reason do bubbles form? Differing schools of economic idea have their opinions:

• Keynesian economics, based on the twentieth century theories of John Maynard Keys, would point to speculation, or emotion-driven buying and selling based on demand, earnings growth, or often mere potential. These actions are based on herd mentality or, a phrase Keys coined, called animal spirits. He believed that when people rely on instinct and feelings to make decisions, their ability to act rationally becomes distorted. Therefore, when we amplify this impulse by a large number on the off chance that not great many times for every investor trading the markets, personal emotion can actually fuel market phenomena, for example, market bubbles, run-ups, selloffs, and even recessions.
• Other ways of thinking blame artificial manipulations from sources like the Federal Reserve, which manages the economy by printing currency and setting, raising, and controling interest rates. They believe such interventions can actually hurt the market's natural cycles of growth and contraction.
• Likewise, there are the essential microeconomic principles of supply and demand: When a new technological innovation is introduced, it generates a frenzy of interest, or when there are supply shortfalls, the shortages can drive an asset's price skyward.
• Furthermore, to those who subscribe to efficient market theory, bubbles actually don't exist, because they believe that prices always reflect intrinsic value.

Whatever the hypothesis, there is one thing that everyone can agree on: investors are oftentimes unaware that a bubble is brewing until it's too late.

What Are the 4 Stages of a Market Bubble?

Bubbles materialize through four stages:

1. "Smart money" investment: Early-in investors notice a new opportunity emerging from the fundamentals and often stealthily build their positions. Momentum accelerates.
2. Mainstream awareness: The asset has already increased in value, often essentially, triggering attention from more mainstream investors, including the media. The smart money might sell some of its holdings, and volatility increases.
3. Peak frenzy: Everyone needs a "piece of the pie," triggering analysts to wonder whether the appreciation will last forever, or on the other hand on the off chance that an end is in sight. Investors use leverage and debt to further increase their positions, often when the asset has become overvalued. Alan Greenspan's phrase "irrational exuberance" is applicable here.
4. Selloff: A paradigm shift happens, and opinion changes — whatever the reason. Investors begin frantically offloading their positions, and the asset's price falls steeply and dramatically. Overleveraged investors can lose big, yet the smart money might begin building new positions, and the cycle might begin once more.

Common Types of Market Bubbles

Generally speaking, financial bubbles fall into distinct categories:

• Equity bubbles inflate around insatiable demand for tangible assets. One example would be the technology stocks that made up the dot com bubble of the late 1990s.
• Debt bubbles have to do with credit-based, or intangible, investments. One example from this category would be the corporate bond bubble that took place after the financial crisis of 2007-2008. The consequences of debt bubbles include debt deflation, or a rise in loan defaults, bank failures, and even currency collapse.
• Combination bubbles, which happen when equity bubbles are financed with debt, can be especially devastating. One such example would be the housing market bubble of 2008, which threatened to destroy the U.S. economy and led to a global financial crisis.

What Happens When a Market Bubble Bursts?

Pop goes the bubble! When a market bubble bursts, demand falls, and prices decline quickly, just like water evaporates rapidly when a soap bubble is popped. Investors who established positions near the top could see their profits erode completely.
Depending on its size, a deflating bubble can have short-term effects to an industry or market niche, however it could also prompt bigger-picture consequences, for example, what befell the housing market in 2007-2008: The downturn in the U.S. housing market snowballed into a national recession and led to a global monetary crisis. History has proven that combination bubbles, or equity bubbles fueled by debt, are the most severe.

Why Is It So Hard to Spot a Market Bubble?

Perhaps it shouldn't be difficult to notice a bubble brewing — on the off chance that emotion really does move the markets, and investors are compelled by fear and greed, then all too often, they fool themselves into thinking they are seizing on a hot opportunity, when in reality, they're buying a bubble going to burst. Typically, bubbles happen around a paradigm shift, like the presentation of a new technology — the tech boom of the late 90s, or advancements made in the nineteenth Century transportation industry, with canals and railways, are two great examples.
So whenever demand surges or someone says, "this is unlike anything we've ever seen before," observing is wise. Examine the fundamentals behind the stock you're going to purchase. Metrics like P/E ratios can help determine on the off chance that a stock is overvalued.

How Might I Tell If We're in a Bubble?

In an effort to shed light on (and extinguish) future financial crises, the Federal Reserve has put together a rundown of common indicators that can help identify bubbles and in this way minimize their damage.
It has even created an "Exuberance Index," developed by Pavlidis et. al (2015), which is applied to the housing market. This index measures housing prices, price-to-income-ratios, and price-to-rent ratios to determine instances of explosive growth. On the off chance that prices are rated higher than a critical threshold of fundamentals, there is supposed to be "exuberance."

A Few Historical Financial Bubbles

Believe it or not, the principal financial bubble had to do with tulip bulbs. In the seventeenth century, demand for the cheerful flower caused farmers to experiment with species and shading, thus the tulip became an object of speculation. In fact, they were so prized, people literally mortgaged their homes during Tulip Mania to buy and afterward resell tulip bulbs. Suddenly, consumer confidence eroded, and the market for tulips crashed. They became all yet worthless and many believe they led to a year's-long economic decline all through the Netherlands.
The 1980s witnessed an asset bubble in Japan's real estate market. Prices became inflated from flooding demand, limited supply, and seemingly endless credit. Speculation was rampant, yet by the early 1990s, the bubble had burst, leaving Japan's economy in a state of stagnation that would last nearly a decade.
The sky seemed to be the limit for fledgling U.S. technology companies during the 1990s. The emergence of the internet and its numerous possibilities fueled a surge of investment — as investors were eager to place their dollars into anything tech-related, and prices soared on little fundamental valuation. When earnings were reported, these tech companies had fallen short of their mark, and their stocks crashed, leaving many bankrupt.

Are We In a Bubble?

RealMoney's Jim Collins believes we are currently in an "everything bubble." Find out why here.

Features

• This fast inflation is followed by a quick decrease in value, or a contraction, that is sometimes referred to as a "crash" or a "bubble burst."
• A bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets.
• Bubbles are typically attributed to a change in investor behavior, although what causes this change in behavior is debated.