What is a bubble?
A bubble is a type of economic cycle characterized by an immediate increase in market value, notably in asset prices. This rapid inflation is followed by a rapid decline in value, sometimes known as a “crash” or “bubble burst.”
A bubble is often formed by an increase in asset values caused by irrational market behavior. During a bubble, assets often trade at or near a price that far exceeds the asset’s inherent worth (the price does not align with the fundamentals of the asset).
Economist opinions differ over the source of bubbles; some even question whether bubbles exist at all (on the basis that asset prices frequently deviate from their intrinsic value). However, bubbles are often discovered and examined only after a significant collapse in prices has occurred.
An economic bubble develops when the price of goods increases considerably above its actual value. Bubbles are often ascribed to a shift in investor behavior, albeit the exact reason for this shift is unknown.
When there is a bubble in the equity market or the economy, resources are shifted to sectors of fast development. When a bubble bursts, resources are redistributed, resulting in prices dropping.
The Japanese economy underwent a bubble following the partial deregulation of the country’s banks in the 1980s, this resulted in a significant increase in real estate and stock values. The dot-com boom, often known as the dot-com bubble, was a late-90s stock market bubble. It was defined by excessive speculation in Internet-related enterprises. People acquired technology stocks at high prices during the dot-com boom, assuming they could sell them at a greater price until confidence was lost and a massive market correction happened.
Why do bubbles matter aside from the collapses resulting from their excess? They are essential because they not only move wealth from greater to lesser ignoration but also to the knaves who prey on the former. They occasionally – and vitally – transfer wealth to fortunate opportunists and bright entrepreneurs in the market economy who are given access to capital on advantageous terms and put it to work with spectacular results.
How do they form?
The price of an item does not suddenly skyrocket – so where do these economic bubbles emerge from?
Economic bubbles often arise in five stages:
When a modest first wave of investors sees and invests in an opportunity, it is referred to as the displacement stage. They’re pleased, and they’re attempting to get their friends and coworkers enthusiastic as well.
How housing bubbles begin is a clear illustration of the displacement stage: the Federal Reserve Board of the US reduces mortgage interest rates to below 3%, and investors and prospective homeowners alike become “excited” and start purchasing.
The displacement stage is sometimes triggered by a single investor’s “eureka” moment. This is precisely what happened in 2019 when a single Reddit video set the groundwork for the infamous GameStop investment mania of winter 2020-2021.
During the displacement stage, prices also stay relatively stable. There aren’t enough buyers yet to push prices soaring. Instead, the initial wave of investors is quietly picking up available goods while whispering, laughing, and clinking champagne flutes.
The media then takes notice.
When the wider public becomes aware of the potential, a second, larger wave of investors begins to pour money into the investment opportunity. Booms usually start when the mainstream media catches on to the subject.
During the boom period, prices begin to rise, but not everyone is on board. Instead, booms tend to attract investors who already have their fingers on the proverbial trigger. This might include:
- Institutional Investors.
- People waiting for the proper time to purchase a house.
- Retail traders with an existing trading account.
In a nutshell, those who were prepared.
The boom period provides an ideal chance to emphasize one of the most significant early warning indicators of an economic bubble.
During normal market conditions, an asset’s price tends to remain stable. Prices will increase linearly if demand rises, or the stock performs well. However, in an economic bubble, prices grow at an exponential rate.
During the euphoria stage, investors from the boom phase begin to reap the benefits of their investments and earn money, causing others to notice and invest.
Nothing better describes the euphoric stage than the “trendies” or “gains” posts on high-risk investment websites. These are posts where inexperienced investors brag about how much money they’ve gained or what they’ve purchased during the boom period:
Many non-investors experience FOMO (fear of missing out) induced euphoria during the euphoric period. The fear of missing out on society’s next gravy train is such a strong motivator that the euphoric stage of an economic bubble generates new investors.
According to the Washington Post, over two million individuals downloaded trading applications during the GameStop (GME) euphoric period to acquire shares.
During the profit-taking period, experienced institutional investors begin to withdraw their funds. As a result, prices start to decelerate and level out, signaling that more experienced investors will fall into line.
In some situations, experienced investors withdraw because they detect indicators of an economic bubble. In other cases, investors are well aware of being part of a financial bubble and exit while their investment value is at or near its expected high. The key is to know when to get off the ride.
To conclude, the profit-taking step is defined as follows:
- Experienced investors begin to withdraw
- Default rates increase
- Asset prices begin to fall
The euphoria has worn off, prices are no longer exploding, and expert investors are mumbling and slinking toward the exit. Then someone activates the fire alarm.
As the name indicates, the panic stage happens when everyone wants to pull out. This is what economists frequently point to as the moment a needle pricks the bubble.
Experiential investors rush for the exit, dumping their shares before values fall. Less experienced investors are holding out hope. Anyone who has purchased the asset on credit risks profound implications from their creditors, who are also in a vulnerable situation.