Financial Bubble

What is a Bubble?

A bubble is a situation in which there is a sudden and excessive increase in the prices of the assets. In the world of finance and economics, the prices of financial securities like stocks, bonds, etc. start making a dream run with continuous increase. And this increase or the prevailing prices goes substantially higher than their fundamental or intrinsic value. In summary, the prices of financial securities defy and ignore any logic with regard to their valuation. And investors still are ready to buy and pay for those assets such a higher values/prices. One of the prime reasons for such a bubble is the expectations of a substantially higher future performance of various publicly listed companies.

The financial instability hypothesis developed by Hyman Minsky explains how an economy moves from stability to instability due to the excess optimism of investors and money lenders. There are three stages of debt, first when the loans are extended with a lot of caution. The second stage is where banks are giving out loans to those who are capable and can make timely payments, and the third is where banks are passing loans to candidates who will be unable to repay the interest let alone the principal amount. It is in stage three when the securities surge in price, and the bubble is formed on the basis of euphoria.

Causes of Bubble

Low-interest Rates & Cheap Debt Availability

One of the primary causes of the bubble is the cheaper availability of debt. Whenever there is a bubble burst, the most affected ones are the highly leveraged companies. It is true and happens so when banks and institutions provide credit without a thorough background check. Or when cheaper debt is easily available. Availability of funds at lower interest rates excites and entices businesses to borrow more. And the same phenomenon applies to consumers where they use this to buy more and more or consume more. Lower interest rates will induce consumers to save less and consume more. Increased prices of stocks and increasing security indexes allure the public to shift/withdraw their funds from traditional investments to the stock market.

Alex A Weber, former president of Deutsche Bank says and we quote: “The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles.”

Supply Shortage – Actual or Artificial

This happens when the assets/commodities are in short supply as compared to the current demand scenario. Or when there are expectations of a sudden jump in the demand that can far outweigh the supplies. This scenario can be factual or it can be so created by certain vested interests. In such a situation the hoarding of the commodity/asset will start and the price sees a sudden surge. And finally is such a situation, does not happen or shortly comes back to normal the prices drop/crash. And the bubble around that asset ultimately bursts.

Let us assume that experts and environmentalists predict that in near future the oil-producing countries are planning to cut the production and supply of oil. Imagine the panic across businesses and customers it may create. Simultaneously, investors may see a profiteering opportunity. Each one of them tries their best to buy or transact for an assured supply of Oil or for hoarding with a view to nullifying the impact on their costs. Or to earn a profit by trading when the prices rise in the near term. Hence, there is a sudden demand and rush of buyers which will drive the prices up drastically. Put differently, the oil prices will surge substantially due to an anticipated supply shortage in the future. And after a month or so the decision is reversed and the oil prices drop. And the hoarders as well as forward transactions incur a loss.

Behavioral Finance

A separate segment of finance studies the psychology of investors. It attempts to interpret and analyze their investing patterns, their reactions to market hypes, their reactions to likely losses and gains. Many socio-psychological factors also play a major role in forming a financial or economic bubble. Even when the prices are surging, investors line up to buy within line with the concept of “Fear of Missing Out (FOMO)”

Herd Mentality

One of the most typical examples is – “Herding or Herd Behavior”. Herding is a term that defines the actions and behavior of investors who follow that one big/celebrity investor whom they trust or believe the most. If one reputed investor says ‘X stock is going to perform well all of the followers of that investor are going to replicate his actions. Furthermore, when one sees the quick rise in prices of the asset/commodity/stock, then he also gets an emotional and psychological influence. And the investor joins the crowd in buying more such assets at the current prices, to derive a quick profit. This is the herd mentality or the herd behavior that further pushes the prices of the asset beyond its reasonable value.

Fools Theory

We can explain this through another theory, called the ‘Fools theory’. It says, one fool will try and make profits from rising prices. One person will sell an overpriced asset; another person will buy from him to sell it to another person at further high prices and make a profit. And this way the cycle continues and the asset’s price will continue to rise and the newer and newer investor will continue to buy at higher prices. However, all this comes to a peak point where there are no buyers and only sellers. This will lead to a sharp decrease in prices and thereby the bubble formed around this asset ultimately burst.

Stages of Bubble

A model designed by economist Charles P. Kindleberger states five stages of a bubble:

  1. Substitution: Surging prices of an asset – New innovation, New Technology, Chances of replacing the existing product/commodity with added or improved features. Or at lower cost, etc. All this leads to creating interest of the buyers and investors in this new found product and commodity. So this becomes the first stage where the investors start flocking or analyzing the prospects.
  2. Takeoff: This is the stage where the utility or benefits of this new found product/technology/commodity establishes. The investors and consumers mark this a positive development. And now everyone starts to accumulate/buy this and Speculative trading starts(buy now to benefit from an increase in prices later).
  3. Exuberance: A state of unsustainable increase in prices (euphoria) beyond its reasonable or intrinsic valuation. Or valuation leading to an unsustainable level. 
  4. Critical phase: A decrease in buyers and increase in sellers, dumping/over supply of the commodity.
  5. Pop: The investors and consumers witness the oversupply or understand the state of unrealistic pricing. And finally the Prices crash.

Signs that we are in a Bubble

Focus on Specific Sector

Few sectors are always in the limelight for their way of being innovative, different, and groundbreaking.

Examples

A classic example in the current market scenario is a cryptocurrency, the world is talking about it, contemplating and understanding what it entails. Everyone wants to participate in the profit opportunity.

The Dot-com bubble happened due to the poor business models of many internet-driven companies. That is the problem, such upcoming famous industries take time to adapt themselves to the world. The cost to enter is always high, and the future is uncertain. Sustainability depends on various factors, and any such untoward event can send prices crashing.

Operations dependent on Borrowed Funds

Higher dependency on leverage to purchase assets and run operations. This equally applies to investors who are borrowing on large scale to invest in IPO’s and the stock market.

Baseless Investing

Investors engage in the stock market because of their beliefs and over-confidence rather than based on thorough analysis and fundamental aspects. 

Investor Expecatations Built only on Future Returns

Entire trading in the stock market/commodities/currency market (including forward market) is driven by futuristic perceptions. The analysts, companies, media and other such forces based on future projections will paint an image of more significant returns in the future. Unreasonable/over-optimistic expectations are a building block in the formation of such bubbles. Promising a better future increases the expectations of investors and when it does not turn out so, the bubble bursts.

Naysayers are Ignored

Few are accurate in judging the trend, posing frequent warnings but are often misunderstood, or termed as ‘those who do not get it.’ Being futuristic expectations, the influence of emotion is more rather than rationality. Hence, the investors often ignore the timely warnings and triggers and continue to invest.

Eventually, these experts and their warnings prove right. And then this ignorance and euphoria ultimately land them in severe losses when the bubble bursts.

What will Happen if the bubble bursts?

A bubble can lead to depression, recession, or financial market crash depending on various factors like the amount invested in the sector, or whether it is an asset-specific bubble or it affects the economy as a whole. It also depends on the scale of leverage in the industry or economy when the bubble bursts. A higher amount of debt will cause greater damage and chaos.

Help us make this article better
Share Knowledge if you liked
Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

Leave a Comment