Bubble, bubble, when markets spell trouble

An economic bubble is created when the price of something is driven much higher than what it should be. A bubble can happen any time the price of an asset goes up unrealistically. In Japan for example, the price of real estate surged beyond all expectations in the late 1980s. Apartment prices doubled, some even tripled, in just a few years, but in 1989, that pattern spectacularly changed. Then, with a massive POP – the bubble burst.

It’s not clear why some assets suddenly grow in value exponentially. One theory is that it happens because of herd behaviour. Herd behaviour refers to decisions made by individuals acting collectively as part of a group – often doing something that they would never do on their own. It’s safety in numbers. People find it hard to believe that a large group of people can be wrong, so they jump on the bandwagon.

Economics theorists have identified five stages of the speculative bubble:

  • Displacement stage – when excitement grows about a new product
  • Boom – the demand far exceeds supply, leading to a spike in prices
  • Euphoria – more investors jump on the bandwagon and there is a ‘high’ and a buzz
  • Profit taking stage – some investors start to sell, realising that the prices are too high to be sustainable
  • Panic – the herd mentality goes from buying to selling; prices drop rapidly creating losses

One of the most famous was the tulip bubble of the 17th century. Tulip Mania is considered to be the first financial bubble crisis; the exotic bulbs, imported to the Netherlands from the Middle East, became so sought after – an irresistible status symbol - that some rare speciality varieties of bulbs were the same price as an entire house. The wealthy Dutch collectors were mesmerised by their changing colours and their exoticism. “There were a lot of people who had money to spend,” according to Professor Anne Goldgar of King’s College London’s History department. “The same people who bought paintings tended to be the people who bought tulips.”

Professor Goldgar describes the crash that resulted, when people realised the market was unsustainable and that the bulbs were fundamentally over-priced (especially as the supply started to increase), as not being as bad as the story suggests. However, the hype to buy the bulbs and subsequent losses once the bubble burst, illustrate very well, the phenomenon of an economic bubble.

More recently, we had the dotcom bubble of the late 1990s. This was when investors put a great deal of money into internet-based companies, which led to a rapid rise in US technology stock prices. In the five years between 1995-2000, the Nasdaq index rose from under 1000 to more than 5000. And then a year or so later, POP – the bubble burst. Many so-called dotcoms went out of business as the Nasdaq dropped by 77% and billions of dollars were wiped out.

One of the remarkable things about the dotcom boom was that there was so much confidence in the market and “irrational exuberance,” as one analyst puts it, that companies which had not yet made any profit, not even any revenue in many cases, or even a finished product in some instances, where still much in demand on the shares market.

Currently all eyes are on crypto-currencies and their future, with all the hype surrounding them and the many dramatic price shifts they face (view our article on crypto).

“There’s only one sure way [to spot an economic bubble],” suggests global chief economist, Joseph Davis, of the advisory group Vanguard, “and that’s after the bubble has burst.”

Recommended links

The NYSE and NASDAQ: How They Work (investopedia.com)

The truth about Tulip Mania - BBC News

Economics of Speculative Bubbles | tutor2u

From Tulips To Bitcoin: Why Investment Markets Are Forever Blowing Bubbles – Forbes Advisor UK

Asset Bubbles Through History: The 5 Biggest (investopedia.com)