Understanding financial bubbles, asset bubbles, stock bubbles and the impact of demand-pull inflation

What is a bubble?

­­The definition of a bubble refers to when the price of a commodity, security, or other financial instrument increases to a point where it is cannot be reasonably supported by its underlying fundamentals. A financial bubble can occur in a single stock or security, or it can spread to include other assets in a ripple effect across a sector.

Eventually, bubbles burst. Some investors might recognize that the fundamentals are off and sell their assets before an asset bubble bursts. Banks and other institutions that are over-leveraged may begin to sell their holdings, causing prices to fall. Investors may then become panicked during a stock bubble and start selling their own stocks, causing the sector to dive and prices to plummet. Knowing the terms of a bubble definition and recognizing the signs might help investors avoid losses.

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Since the economic recession in the late-2000s, the U.S. economy has entered into an extended bull market. This has created a group who warns that there is a current wealth bubble that may burst in the next several years. Historically, household wealth has roughly tracked the GDP at an average of 379 percent. Currently, however, household wealth stands at around 505 percent of the GDP, and this gap is causing an increasing number of people to sound the alarm.

Fund managers point out that tech stocks have continued to rise in price while defensive stocks like healthcare and telecoms have been losing out. The high-priced tech stocks may be likely to drop if the asset bubble bursts. It might make sense for people to turn their attention to defensive stocks before the burst.

What is the impact of demand-pull inflation on a stock bubble?

This type of inflation occurs when the demand for a stock or asset is much higher than the supply. As consumer demand increases, companies try to increase the supply to meet demand. When additional supply is not available, the stock price increases. This causes inflation.

One example of the impact of demand-pull inflation on a stock bubble occurred with the creation of credit-swap securities before the economic recession of the mid-2000s. As the demand for credit-swap securities rose, the price of the underlying assets also increased. This meant that housing prices ballooned up to more than their true values before the housing market collapsed.

Background on financial bubbles

There are several types of bubbles which have different effects on the economy when they burst. Economists have been researching bubbles for hundreds of years to study the signs and lessons that can be applied in modern markets.

Some of the common financial bubbles include the following:

  • Equity bubbles without credit bubbles
  • Credit-fueled equity bubbles
  • Housing bubbles with average credit growth
  • Leveraged housing bubbles

Equity bubbles that are not financed with credit do not have as great of an impact on the market as other types of bubbles. Credit-fueled equity bubbles may have a greater impact and might make recovery slower and prolong recessions when the bubbles burst. An example of this is the high-tech stock bubble that occurred in the late 1990s to the early 2000s.

Housing bubbles with average credit growth may cause more damage than equity bubbles. Leveraged housing bubbles may cause the greatest damage as demonstrated by the housing bubble in the mid-2000s. On average, it can take an average of five years for the economy to recover after a leveraged housing bubble bursts.

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Hyman Minsky was a post-Keynesian economist who developed his theory in the mid-1970s. According to Minsky’s Theory of Financial Instability, economic crises are unavoidable in capitalist systems because prosperous times encourage people to become increasingly reckless.

Minsky tied the boom and bust cycle to debt accumulation in the private sector. He identified three groups of borrowers that contribute to the building of insolvent debt that can cause a bubble to burst, including hedge, speculative and Ponzi borrowers.

Minsky’s theory was given new attention following the sub-prime mortgage crisis. Hedge borrowers were the borrowers who took out traditional mortgages and made payments to both the principal and interest. Speculative borrowers were people who took out loans with interest-only payments. Ponzi borrowers took out loans that did not fully cover the interest, so their balances increased. A combination of these three types of debt accumulation led to the crisis that followed.

Bubble characteristics

Minsky identified five stages of economic bubbles, including the following:

  • Displacement
  • Boom
  • Euphoria
  • Profit-taking
  • Bust

During the displacement phase, investors become enthralled by a new paradigm including low interest rates or new technology. This is the point at which investors begin to enter the market. During the boom phase, the number of investors increase and drive up prices. Following widespread media coverage, investors flood the market, causing prices to soar.

Following the boom phase, a stage of euphoria occurs. This is when investors start throwing caution to the wind and become increasingly speculative. Valuations may reach extreme levels that are disproportionate to the stock fundamentals. Finally, a bust occurs. This is the bursting of the economic bubble, resulting in sharp declines in the valuations. As the prices fall, investors panic and sell their holdings, causing the prices to fall even more.

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How do financial bubbles work?

A bubble occurs when the price of a financial asset like a stock, bond, real estate, or commodity increases at a rapid pace without underlying fundamentals to support the increase. The price spike of a financial asset attracts opportunistic speculators and investors to jump in. They then drive the price up even higher, which leads to further price increases and speculation that are unsupported by market fundamentals.

Inexperienced investors may not recognize the signs of an economic bubble. Instead, they notice the price spike in the financial asset and believe that they can profit from the rising prices. Then there is a flood of investment dollars into the asset, which drives the price up to unsustainable levels and creates the financial bubble.

Causes of a financial bubble – Keynesian Economics

The founder of Keynesian theory, John Maynard Keynes was an English economist whose theories largely shaped the economic approach today. Under the Keynesian theory, the government is encouraged to play a large and active economic role. As a result, Western economies today are characterized by huge central governments that carry massive debt, and Western governments largely follow the principles of Keynesian economics.

The Federal Reserve is responsible for establishing interest rates in an effort to control the economy and the financial market. When the interest rates are low, people are encouraged to borrow and to spend. Consumer demand for a product or an asset may outweigh the aggregate supply, driving inflation.

There are several causes of demand-pull inflation, including the following:

  • Growing economy
  • Asset inflation
  • Governmental intervention
  • Economic forecasts and expectations of inflation

When there is too much money in an economic system that has too few goods, the prices will go up. If there is a supply shortage of an asset class that is in high demand in a financial market, the prices may dramatically increase. The increase may spur other investors to get in to purchase securities in the asset class, eventually leading to the valuations to increase far higher than the intrinsic value of the financial assets contained within the class. This can lead to a financial bubble, which will eventually burst.

What causes a bubble to burst?

Several factors can cause the bursting of an economic bubble. The demand for assets can eventually become exhausted. This can lead to a downward shift that pressures prices in a descending spiral.

There can also be a slowdown in another area of the economy. This can shift the overall demand curve in a downward direction, causing prices to plummet.

In the short-term, financial bubbles can be devastating. However, Hyman Minsky viewed the bursting of economic bubbles as more of a feature of the market rather than a failure of it. In the long-term, the bursting of a bubble may lead to new technology, new infrastructure, and improvements in the overall economy.

Examples of financial and asset bubbles

Three of the largest bubbles in history demonstrate how bubbles work and what their aftermath can be. The first of these three examples occurred in Holland in the 1630s. The Dutch Tulip Bubble is an example of an asset bubble where the prices of tulips soared by 20 times in the three-month period from Nov. 1636 to Feb. 1637. By May 1637, the bubble burst, and the price plummeted by 99 percent.

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Another example of a financial bubble was the South Sea Company bubble, which happened in 1720. The British government promised the South Sea Company that it would have a monopoly on all of the trade with the South American Spanish colonies. The directors of the company spread tall tales about the riches in South America, leading to investors snapping up shares. The company’s stock price increased by eight times in 1720 from January to June. The burst of the bubble led to a severe economic downturn.

A more modern example of a stock market bubble is the Dot-Com Bubble of the late 1990s. The internet’s introduction in the 1990s led to a speculative bubble around new technology companies. Hundreds of internet companies were valued in the multi-billion range as soon as they completed their initial public offerings. However, these valuations were not supported by the intrinsic value of the companies or their fundamentals. This led to the Nasdaq index soaring to over 5,000 by 2000. By 2002, it had dropped by 80 percent and plunged the economy into a recession and bear market.

Investing during a bubble

The key to investing during a bubble is to identify the phases so that you can recognize that a bubble is forming. The earliest phase is when there is a new development or technology that has market promise. Smart money investors who are able to spot when an asset price bubble is beginning to form may get in early before widespread media coverage drives up prices further.

Holding the securities through the awareness phase when more investors jump in and then selling them during the mania phase can help smart money investors to capitalize on the asset price bubble. However, timing when to get in and when to get out can be difficult when you are trying to invest in an asset bubble. It is important for you to be able to get out before the demand is exhausted and the prices begin to fall.

It is best to avoid trying to time the market during a bubble. Instead, you should take steps to protect yourself during a stock market bubble.

To protect yourself from an asset bubble or a stock market bubble, buy shares of strong businesses that have good fundamentals. Choose companies that generate real profits and that have attractive returns on equity. The companies should have low to moderate debt-to-equity ratios and should also show improvements in their gross profit margins.

You should incorporate the dollar cost average strategy into and out of your positions. Buying and selling at fixed rates and set amounts of money to provides more protection from asset price bubbles. People who dollar cost average buy more shares of a security when the prices are lower so that their positions are worth more if the price goes up.

Reinvest your dividends for added protection from financial bubbles. When you reinvest your dividends, your money is able to work harder for you over a longer period of time. Keeping your costs low by choosing a brokerage firm that charges low or no fees can also help. Make certain that you create backup cash generators and passive income sources so that you are able to ride out the leaner times of bear markets while you wait for the bull market conditions to return.

Diversification of your portfolio and rebalancing are also important ways to protect yourself from price bubbles. If your portfolio is diversified well across a variety of different classes of assets and types of securities, you may be protected from a price bubble that might occur in one of your investments. Pay attention to the fundamentals of the companies that you choose so that you can recognize whether a stock’s price exceeds its intrinsic value. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.

At regular intervals, check your portfolio and rebalance it. This involves reallocating the weights in your portfolio to match the percentage allocations that you have predetermined. Rebalancing your portfolio and investing with a long-term view can potentially help you to realize greater returns while allowing you to ride through bear markets and profit from bull markets as they occur over time. Rebalancing can entail transaction costs and tax consequences that should be considered when determining a rebalancing strategy.

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