What’s the Deal with Economic Bubbles?

There has been noise in the financial sector about a possible upcoming bubble.  We should begin preparations.  A bubble you say?  That doesn’t sound so bad.  Hold on a second, what’s a bubble?

If you are like most people, you have a deep rooted desire to understand economic bubbles.  I am sure your heart is racing at the very thought that you are finally going to unlock the mystery.  Within a few weeks of reading this, don’t be surprised if your social life has been multiplied by 10.  Knowledge of bubbles can be life altering and frankly everyone will want to talk to you.  So, if you enjoy your quiet Saturday nights at home, then this reading is not for you.  Don’t say I didn’t warn you.

What Is It?

Don’t be at all embarrassed if when I say “bubble”, you have no idea of what I am talking about.   It is not common knowledge.  To make it more confusing, they can masquerade under the names of economic bubble, asset bubble, speculative bubble, price bubble or even balloon.  Okay, enough delaying the suspense.  A bubble is a rapid rise of asset prices that does not follow underlying intrinsic value.  Because this rise can only be sustained for so long, the bubble eventually “pops” which causes prices to fall dramatically.

Asset prices should accurately reflect intrinsic value based on current and future earnings.  So, why does an asset not stay closely tied to its actual value?  Well, if you had a hunch that future value would increase, wouldn’t you be willing to pay more for it today?  During a bubble, that is exactly what happens.  People simply get swept up in the frenzy as the price goes up which drives it up even further.  I wish I could say it is uncommon but unfortunately it has happened numerous times throughout history.  It is usually not until the bubble has popped that it is recognized.

A Tulip Bubble?

Imagine I am a salesman armed with a sharp looking suit, an infectious smile and profound ability for closing sales.  The product I am selling is the tulip bulb.  Is there any way I could convince you to pay 5-6 times your salary for my product?  Are you telling me it doesn’t sound like a good investment?  Despite how ridiculous it sounds, there was a time when tulip bulbs developed into an uncontrolled bubble.

One of the first bubbles was formed in Holland in the 1630s.  When tulip bulbs were first brought to Holland, a furious buying and selling fire was ignited.  Prices soared as demand for bulbs increased.  Rare bulbs were especially profitable and only attainable by the wealthy.  At one point, people were trading land and homes for the chance to make money in the tulip market.  It has been reported that three tulip bulbs could buy a house.

Speculation ran rampant as a futures market was formed.  Through the futures market, tulips could be bought and sold through contracts with a specific “future” delivery date.  Like a stack of cards, it eventually all came tumbling down.  The bubble could no longer sustain itself and people began to realize the tulips’ actual value.  A massive selloff ensued and many family fortunes were lost.

You may be thinking to yourself (hopefully not yelling at your computer screen), why would these people be so dumb and get caught up in this?  The tulip bubble, reminds me of the beanie baby or tickle-me elmo frenzies of the 1990s.  In hindsight it seems utterly ridiculous but at the time buying and selling rare beanie babies could be very lucrative.  Rational people can even act irrational with the right societal/monetary pressures.

Bubbles and More Bubbles

My daughter loves chasing bubbles on a summer day.  In fact, she loves it so much we usually can’t stop until the bubble solution is completely gone.  Unfortunately, bubbles in the economy are not as loveable.  In fact, some bubbles can decimate an economy resulting in recessions and sometimes depressions.

There have been a number of major bubbles in U.S. history including one in the 1920s which resulted in the great depression, the tech bubble in 1990s-2000s and the housing bubble that popped in 2008.  Each bubble had key factors leading to its formation.  For example, the most recent housing bubble was the consequence of low interest rates brought on by the federal reserve, beliefs that home prices would not decline, creative sub-prime financing and over leveraging through mortgage backed securities.  As home owner’s lost jobs, mortgage rates went up and housing prices declined, the U.S. and global economy crashed.  We are still dealing with the effects today.

Why Do These Bubbles Form?

The primary driving factor of a bubble is an extremely strong demand.  No demand, no bubble.  But what causes people to “demand” an asset?  Demand is typically brought on by a combination of fundamentals and psychological forces.

Asset prices don’t tend to go up without some fundamental drive based on analysis of financials.  Often times, an asset is found to be undervalued.  Due to undervaluation, the asset is flooded with buyers.  End result; an elevated asset price.  This is normal and in most cases it stops here.  But sometimes it doesn’t and a bubble begins to take shape.

I don’t know about you, but I like to have and make money.  For some reason, a certain amount of money makes life easier.  It is tough to stand on the sidelines while others are making a quick buck.  Especially when on the surface it seems to be a “sure thing”.  Envy and greed can cause you to pull money out of savings and join in.  After all, the majority of people can’t be wrong, right?  This is known as herd instinct.  Yes, underneath our designer clothes and superior analytic skills, we are animals.  As animals, we can be herded into behaviors that in hindsight are irrational.  During bubble formation, herd instinct causes a positive feedback loop in which prices get driven higher and higher.  The higher the prices go, the less sustainable they become.

At some point, rationality returns and money gets pulled out of the asset as the bubble “pops”.  Ah, the fun is over.  Everyone go home, there is no more money to be made.  While some people merely lose part of their fortunes, others are left curled up and rocking themselves in the fetal position.  The people who arrived late to the party are especially damaged.  Prior “investors” are left wondering “what just happened” and “where did I go wrong”.

Even though bubbles typically occur in one asset class, there is sometimes spill over into others.  For example, when mortgage payments stopped during the housing crisis, lending firms began to get squeezed.  In order to meet financial obligations, these firms had to sell off assets.  The sale of these assets further exacerbated the financial market drop.

Why Don’t We Prevent Bubbles?

All bubbles are preventable.  The way we prevent bubbles is to go back in time and warn investors ahead of time.  It is that simple.  No more bubbles.  There, I solved it.  Phew, that took a lot of brainpower to solve, but finally we can all rest assured there will no longer be bubbles.  If only it were that easy.

Bubbles are part of the stock market.  Even in stocks such as Apple, there are mini-bubbles.  For example in December 2011, Apple shares sold for around $56/share.  Nine months later, Apple topped out at $100/share.  Did the company significantly increase its value or was it investor mania?  I would say it was more of the latter, because 7 months later the price was $60/share.  My condolences go to those who rode the ride only from the peak to the valley.  The good news is if you held on, the stock recovered back up to $100/share 17 months later.

I am paraphrasing, but I once heard from Warren Buffett “in the short term, the stock market is consistently unpredictable, but in the long term it has a tendency to go up”.  That is why a buy and hold strategy is still a good sound plan.  Bubbles are caused by speculation in which high risk transactions take place with the expectation of substantial gain.  Let’s get this straight, speculation is NOT investing.  If you let speculation dictate your choices, then you are in for a wild ride.

There have been escalating fears about an upcoming bubble which could unravel the stock market.  To counteract the housing market crash in 2008, the Federal Reserve lowered interest rates to stimulate economic growth.  Lower interest rates can lead some people to use borrowing to speculate instead of personal use.  This is probably why some economists conceive lowering interest rates to be an exacerbation of a bubble.

Neither you nor I can accurately predict when a bubble will decide to pop.  In a recent CNN Money interview, investor and former Vanguard CEO Jack Bogle stated “I don’t think it’s a bubble.  I think it’s a significant high valuation, but not a bubble.”  Warren Buffet is also optimistic and confirms the U.S. to not be in bubble territory despite the recent post-election rally.  He feels stocks are “cheap” based on interest rates.  The key message is to avoid pulling your money out of the market and stay invested.

Conclusion

It is a matter of fact that bubbles will form and bubbles will pop.  There is no stopping it.  It has happened throughout history and they are only obvious in hindsight.  Don’t become “bubble-shy”.  Try to keep yourself together and don’t start hoarding gold, building a bomb shelter or collecting emergency food rations.  The only thing an individual can do to minimize the effects of a bubble is avoid getting swept up in the commotion.  Now that you understand the ins and outs of bubbles, the next thing to do is go impress your friends.

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