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 as 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 give 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.
- What is a Bubble?
- Causes of Bubble
- Signs that we are in a Bubble
- What will Happen if the bubble bursts?
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. The availability of funds at lower interest rates excites and entices businesses to borrow more. And the same phenomenon applies to consumers who 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 will see a sudden surge. And finally, if 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 the near future, 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.
A separate segment of finance studies the psychology of investors. It attempts to interpret and analyze their investing patterns, their reactions to market hypes, and 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).”
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.
Also Read: Inflation
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:
- 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 the interest of the buyers and investors in this newfound product and commodity. So this becomes the first stage where the investors start flocking or analyzing the prospects.
- Takeoff: This is the stage where the utility or benefits of this newfound product/technology/commodity establishes. The investors and consumers mark this as 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).
- Exuberance: A state of unsustainable increase in prices (euphoria) beyond its reasonable or intrinsic valuation. Or valuation leading to an unsustainable level.
- Critical phase: A decrease in buyers and increase in sellers, dumping/oversupply of the commodity.
- 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.
A classic example is 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 borrow on a large scale to invest in IPOs and the stock market.
Investors engage in the stock market because of their beliefs and over-confidence rather than based on thorough analysis and fundamental aspects.
Investor Expectations Built only on Future Returns
Entire trading in the stock market/commodities/currency market (including the 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 investors’ expectations, and when it does not turn out so, the bubble bursts.
Naysayers are Ignored
Few accurately judge 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.