Economic bubbles can be extremely profitable and equally devastating, depending on where you sit. An economic bubble is when asset prices run up in value rapidly, followed by a major contraction, as in the case of the housing bubble of 2007-2008 or the Tech Bubble of 2000-2002.
What is an Economic Bubble?
Economic bubbles are created when there is a surge in the prices of assets, not in line with the fundamentals of the asset, but rather by an excited market behavior. When there aren’t any investors willing to buy into the elevated prices of the assets anymore, a major selloff occurs, causing the bubble to burst.
Bubbles occur in economies, securities, stock markets and business sectors because of a major shift in the behavior of investors. Economists have debated whether bubbles can be identified, or even stopped, before they can cause widespread damage.
Dutch Tulip Mania
However, spotting bubbles isn’t easy, as in the case of the Dutch Tulip Bubble of the 1630s. At the peak of Tulip mania, as it was called, some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman. For a flower, for Pete Sake!
Spotting a Bubble
For many investors, more important than spotting a bubble, is whether it’s possible to avoid getting sucked into a bubble at its top end and suffering dramatic declines as the case of the 80% drop in technology stocks in 2002.
It’s notoriously difficult to time the stock market. As a result, there were several occasions, during the last century, when the markets doubled over three years. After the rise in these cases, the markets then dropped by half in the following year on less than one in 20 occasions.
The market dropped by half of their value over the next five years around one tenth of the time. And in a fifth of these occasions, the market went on to double again. With this in mind, a sharp rise in the market is a buy signal, rather than a sell signal. This explains why investors find it so difficult to get out of the market at its peak.
Financial Definition of a Bubble
One of the problems with spotting economic bubbles is economists don’t agree on the actual definition of a bubble in the first place. One concept to defining a bubble is that it occurs when the price of an asset rises by more than two standard deviations above its previous long-term trend.
Another approach is to look at the fundamentals. Typically, asset prices are expected to reflect the current value of future cash flows. In theory, a doubling in the market could reflect a sudden improvement in the outlook for that asset class.
One reason there a several different opinions on what is the start of an economic bubble is that bubbles aren’t usually obvious until they’re underway, or more to the point, when they have already taken a turn.
What could seem like the “next big thing” may not reveal itself to be a catastrophic economic bubble until it bursts, as in the case of the tech bubble that occurred at the beginning of the new millennium.
The Tech Bubble
The tech bubble, or dot-com bubble, was a purely speculative bubble that occurred around 1995 – 2001 when the stock markets in industrialized countries saw their equity value rise rapidly, and extraordinarily, due to the growth in the internet sector and related fields.
Since the tech bubble was caused by the recent rise in the internet it seemed that it was a result of the current times and the ever increasing use and value of the World Wide Web itself. People figured that there was nowhere to go but up.
The Birth of the Day Trader
One factor that fueled the bubble to greater and greater heights was the introduction of easier, less expensive stock trading. This allowed anyone the ability to easily and affordably trade stocks. This lead to “day trading” by inexperienced investors. People were buying stocks and holding them for a day, or even a couple of hours and then selling them. When the great sell off came in 2001 it was catastrophic.
Timing the Market
None of this is very encouraging since there really isn’t one effective way to spot a bubble until it’s too late. However, it makes sense because if timing the market were possible, major price swings wouldn’t be an issue in the first place.
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