What Is a Bubble?
A "bubble" refers to a situation where the price of an asset such as an individual stock, or a sector, market index as a whole, a financial asset (combination of stocks, debts etc.), or an asset class such as Real Estate, Precious metal, Commodity/es exceeds its fundamental value by a large margin. This may happen from speculative demand, rather than intrinsic worth, fuels the inflated prices, the bubble eventually but inevitably pops, and massive sell-offs cause prices to decline, often quite dramatically. In most cases a speculative bubble is followed by a spectacular crash in the securities or an asset class in question.
Some economists have identified five stages of a bubble—a pattern to its rise and fall—that could prevent the unwary from getting caught in its deceptive clutches.
The damage caused by the bursting of a bubble depends on the economic sector(s) involved, and also whether the extent of participation is widespread or localized.
5 Steps of a Bubble
Types of Asset Bubbles
An asset bubbles can be categorised into 4:
1. Equity Stock market bubbles can include stock market indices, ETFs, respective Mutual Fund’s NAV, and Sector etc.
2. Asset Market bubbles involve other industries or sections of the economy. Real estate is a classic example. Run-ups in currencies or cryptocurrencies like Bitcoin.
3. Credit bubbles involve a sudden surge in consumer or business loans, debt instruments, and shadow banking loans (off Balance Sheet landing).
4. Commodity bubbles involve an increase in the price of traded commodities likematerials and resources, such as gold, oil, industrial metals, or agricultural crops.
Stock market and market bubbles, in particular, can lead to a more general economic bubble, in which a regional or national economy overall inflates at a dangerously fast clip.
5 Stages of a Bubble
These stages also outline the basic pattern of a bubble.
1. Displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low. A classic example of displacement is current state of very low or negative interest rates.
2. Boom: Prices rise following a displacement and then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be a once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of investors and traders into the fold.
3. Euphoria: During this phase, caution is thrown to the wind, as asset prices skyrocket. Valuations reach extreme levels during this phase as new valuation measures and metrics are touted to justify the relentless rise.
4. Profit-Taking
In this phase, the smart money heeding the warning signs that the bubble is about at its bursting point starts selling positions and taking profits. But estimating the exact time when a bubble is due to collapse can be a difficult exercise because"the markets can stay irrational longer than you can stay solvent." JM Keynes
5. Panic: In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls (including borrowings against asset) and plunging values of their holdings, now want to liquidate at any price. As supply overwhelms demand, asset prices slide sharply.
Causes of Asset Bubbles: Asset bubbles can begin in any number of ways, and often for sound reasons include:
1. Interest rates might be low, which tends to encourage borrowing for spending, expansion, and investment. Currently we have very low or negative interest rates.
2. Low-interest rates and other favorable conditions in a nation encourage an influx of foreign investment and purchases.
3. New products or technologies spur demand and, whenever something's in demand, its price naturally rises (what the economists dub demand-pull inflation).
4. There are shortages of an asset, causing the cost of it to climb a classic supply-and-demand principles.
Why are they doing this?
It has to do not with fundamentals but with human foibles—psychological and often irrational thinking and actions about money, known as behavioral financial biases.:
1. Herd mentality: doing something because everyone else is
2. Short-term thinking: just looking at the immediate returns, or thinking you can "beat the market" and time a quick exit
3. Cognitive dissonance: only accepting information that confirms an already-held belief, and ignoring anything that doesn't
"Irrational exuberance is the psychological basis of a speculative bubble. & defined a bubble "as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases, and bringing in a larger and larger class of investors who, despite doubts about the real value of an investment, are drawn to it partly by envy of others' successes and partly through a gamblers' excitement."
Conclusion:
"A rapid price rise, high trading volume, and word-of-mouth spread are the hallmarks of typical bubbles. If you learn of an investment opportunity with dreams of unusually high profits from social media or friends, be particularly wary & in most cases, you’ll need uncanny timing to come out ahead."
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