What Is a Bubble?
A bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. 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. Typically, a bubble is created by a surge in asset prices that is driven by exuberant market behavior. During a bubble, assets typically trade at a price, or within a price range, that greatly exceeds the asset’s intrinsic value (the price does not align with the fundamentals of the asset).The cause of bubbles is disputed by economists; some economists even disagree that bubbles occur at all (on the basis that asset prices frequently deviate from their intrinsic value). However, bubbles are usually only identified and studied in retrospect, after a massive drop in prices occurs.
How a Bubble Works
An economic bubble occurs any time that the price of a good rises far above the item’s real value. Bubbles are typically attributed to a change in investor behavior, although what causes this change in behavior is debated. Bubbles in equities markets and economies cause resources to be transferred to areas of rapid growth. At the end of a bubble, resources are moved again, causing prices to deflate.
The Japanese economy experienced a bubble in the 1980s after the country’s banks were partially deregulated. This caused a huge surge in the prices of real estate and stock prices. The dot-com boom, also called the dot-com bubble, was a stock market bubble in the late 1990s. It was characterized by excessive speculation in Internet-related companies. During the dot-com boom, people bought technology stocks at high prices—believing they could sell them at a higher price—until confidence was lost and a large market correction occurred.
The research of American economist Hyman P. Minsky helps to explain the development of financial instability and provides one explanation of the characteristics of financial crises. Through his research, Minsky identified five stages in a typical credit cycle. While his theories went largely under-the-radar for many decades, the subprime mortgage crisis of 2008 renewed interest in his formulations, which also help to explain some of the patterns of a bubble.
This stage takes place when investors start to notice a new paradigm, like a new product or technology, or historically low interest rates. This can be basically anything that gets their attention.
Prices start to rise. Then, they get even more momentum as more investors enter the market. This sets up the stage for the boom. There is an overall sense of failing to jump in, causing even more people to start buying assets.
When euphoria hits and asset prices skyrocket, it could be said that caution on the part of investors is mostly thrown out the window.
Figuring out when the bubble will burst isn’t easy; once a bubble has burst, it will not inflate again. But anyone who can identify the early warning signs will make money by selling off positions.
Asset prices change course and drop (sometimes as rapidly as they rose). Investors want to liquidate them at any price. Asset prices decline as supply outshines demand.