Asset Bubbles That Cost Investors Money

As inflation grows and the stock market seesaws, investors worry that not just one, but several asset bubbles are about to burst. We're in the middle of what some call the "everything bubble." This is a time when a wide range of asset classes could be in bubble territory.

Takeaways

• What is an asset bubble

• Examples of recent asset bubbles

• Warning signs of an asset bubble

Why could there be an asset bubble?

Over the past few years, enthusiastic investors have bid up the prices of assets, many of which have already seen large price drops. These include equities, real estate, cryptocurrencies, and non-fungible tokens (NFTs).

These potential bubbles are a concern for many investors. When a bubble pops, a sell off occurs, causing investors to lose money. In a worst-case scenario, a bursting bubble can lead to economic collapse, recession, and even depression.

What is an asset bubble?

An asset bubble is an economic term used to describe a situation where the price of an asset rises well above its intrinsic value. During a bubble, there is a significant disconnect between the true value of an asset and the inflated price buyers pay for it.

You can have a bubble in all sorts of assets, such as stocks, real estate, oil, and gold. Even a flower can be the catalyst for a bubble. This was the case during the "tulip mania" that gripped 17^th century Holland. The desire to possess tulip bulbs became so immense that entire fortunes were made (and lost) as ordinary people clamored to buy the rarest bulbs.

Factors that accelerate asset bubbles include rampant speculation, herd behavior, and irrational exuberance. Spurred by the fear of missing out (FOMO), investors will ignore any margin of safety and buy into the market without performing due diligence. When the bubble bursts, the price of the asset falls dramatically. This sometimes causes a market crash and economic upheaval.

Asset bubbles and the money supply

One factor that influences the growth of an asset bubble is when a nation's central bank expands the money supply. Often, the purpose of this money supply expansion is to stimulate the economy by encouraging spending in the business and consumer sectors.

For example, the Federal Reserve in the United States might enact policies that lower short-term interest rates. Banks will then lend money to businesses and consumers at a lower rate. This access to cheap money encourages people to borrow to purchase assets, such as real estate. This in turn can cause a spike in housing prices as the demand for real estate grows.

Low interest rates also cause investors to look for higher yields in other investment classes, such as stocks and commodities. Again, this increased demand for alternative investments leads to increased asset prices. The more money a central bank injects into an economy, the greater potential for an asset bubble to form.

If price inflation becomes too high, however, the central bank may enact policies to restrict the money supply. As the flow of money stalls, the growth of an asset bubble also stalls, and the bubble may even burst.

Three famous examples of asset bubbles

Some famous examples of asset bubbles include the U.S. stock market bubble of the 1920s, the dotcom bubble, and the real estate bubble of 2006-2007. In each case, the price of assets—such as stocks or housing—rose to unsustainable levels before crashing spectacularly.

Equity Bubble of the Roaring Twenties

Starting in 1921, the U.S. Federal Reserve began an expansion of the money supply to stimulate the faltering economy. The Fed lowered interest rates and reduced credit requirements. For many Americans, this offered them the first opportunity in their lives to borrow money cheaply. Some people plowed money into commodities, real estate, and the stock market.

The access to cheap money created a frenzy as novice investors entered the markets, which in turn caused prices to spike. With the Fed maintaining its easy money policies, the bubble in equities grew through much of the 1920s. By 1928, however, the Fed began to tighten its monetary policies to tamp down on excessive stock market speculation.

By autumn 1929, it became clear to many investors that sky-high stock prices were unsustainable. On Black Thursday, October 24, 1929, the stock bubble burst, and panic selling ensued. The stock market collapse continued over several trading sessions.

On Black Tuesday, October 29, investors lost $14 billion. The crash resulted in the Great Depression, the longest and deepest economic depression in United States history.

Dotcom bubble

In the mid-to-late 1990s, technology stocks were increasing in value at an alarming rate. This bubble was known as the dotcom bubble after the Internet stocks that fueled the buying frenzy.

Investors and venture capitalists showered money on Internet-based companies, hoping that one day they would earn a profit. The problem was some of these startups had nothing of value to sell. They simply existed as websites touting vague concepts without an actual business model.

By the end of 1999, the euphoria surrounding these new companies began to wane as many reported negative earnings. In March 2000, the bubble burst and stock prices in the tech sector declined rapidly.

Even blue-chip stocks—such as Intel, Cisco, and Microsoft—fell sharply. Many people lost money when the market crashed, and many technology companies went bankrupt. Over the next two years, the Nasdaq index fell over 75 percent. By the end of 2002, investors had lost an estimated $5 trillion.

The real estate bubble of the 2000s

Shortly after the dotcom crash, the Fed began monetary expansion resulting in lower interest rates. This, combined with the relaxed lending standards many banks were offering customers, culminated in a hot housing market by the early 2000s. Attracted by cheap and easy-to-obtain mortgages, homebuyers flooded the real estate market. Prices climbed to record highs and a real estate bubble formed.

Adding to this were government policies that pushed credit into the housing sector through the deregulation of the financial sector. Financial institutions created new home loan "products." This included subprime lending to borrowers who were poor credit risks. Large banks and hedge funds repackaged these high-risk loans into mortgage-backed securities (MBS) and derivatives that they then resold on the global markets.

The bubble burst in 2007 as interest rates adjusted higher. Huge numbers of home buyers defaulted on their loans. By 2008, the global financial markets were collapsing as the full magnitude of these bad loans became evident. The resulting Great Recession led to millions of lost jobs and the loss of $14 trillion in American household wealth.

Bursting bubbles and recessions

What's interesting to note is that not all bursting bubbles result in the same kind of recession. This graph from the Federal Reserve shows U.S. real gross domestic product (GDP) dipped slightly during the dotcom bust between 2000 and 2002. The decline was much greater, however, during the Great Recession following the housing crash of 2007.

According to the Federal Reserve, a reason for this could be the housing bust resulted in a "contagion" that spread from one market sector to another. This contrasts with the relatively isolated impact of the tech crash, which did not have as great an impact on other sectors.

How to spot asset bubbles

When an asset bubble is about to burst, there are usually warning signs you can easily observe. Understanding these signs and being on the lookout for them can help you avoid losing money from an upcoming crash.

One of the most common indicators is a sharp increase in prices. This suggests investors are becoming increasingly optimistic about the future value of the asset. This inflated price does not correspond with a fundamental analysis of the asset, which indicates that it is overvalued.

Another sign that a bubble is about to burst is when it becomes difficult to sell assets at current prices. This could be because people are starting to realize that the market has become over-inflated, or because lenders are starting to become concerned about borrowers' ability to repay their debts. By this time, early investors may have already exited the market by selling and taking their profits.

Finally, if news articles and other commentary start discussing how a particular asset class is in a bubble and could soon collapse, this could also be a warning sign. Prices may begin to fluctuate as irrational exuberance is replaced by skepticism and fear.

Conclusion

A bubble is often characterized by a lot of speculation and borrowing to buy assets, as people hope to make a quick profit. People may move money from more conservative investments to take advantage of what they feel is a "sure thing." Intense media coverage of others making money in the asset fuels the FOMO that propels investors to jump into the market. This kind of situation should be the warning sign for you to prepare for increased downside risk.