Let's envision one of the most beautiful spring-blooming plants species, proudly distinguished by their cut-shaped showy flowers, whose vivid colors can brighten our world in a matter of seconds. If we additionally impart the commonplace symbolism of sincere love that they carry when given to someone, tulips might instantly appear to be a relatively precious gift. So, how much would you pay for a bouquet of them - several dollars? One hundred? Or maybe.... a million?
As much as the last answer might sound like the pinnacle of absurd these days, there actually was a time when particular tulip bulbs were sold for the price equal to the value of an Amsterdam Grand Canal mansion!
The Dutch Tulipmania, speculative frenzy accompanying the rise of 'dot-com companies', or the US housing bubble can be placed among the most acute occurrences of this kind, resulting in surging sky-high prices that have eventually plummeted sorely.
But how exactly do all of these experienced investors get carried away so much by unjustified market excitement?
To answer this question, let's delve deeper into fundamental notions and dependencies underlying economic bubbles and several examples from history, which perfectly illustrate their specifics.
So, what exactly is an economic bubble?
This figurative concept - also known as an asset bubble, speculative bubble, market bubble, price bubble, or even a balloon - is a term used to describe a situation when asset prices are based on implausible, unjustified, and often significantly too-optimistic outlooks on the future. These prices quickly exceed the intrinsic value of particular assets, leading to unreasonably high sums. It can also be pictured as a specific economic cycle of a rapid expansion swiftly followed by a usually dramatic contraction.
How do the bubbles emerge?
One widely accepted theory explaining the reasons behind asset bubbles does not exist. Nonetheless, there is a fundamental mechanism, concisely described by a billionaire investor, Seth Klarman: "at the root of all financial bubbles is a good idea carried to excess."
All right then, so how does this process look in greater detail?
An American economist, Hyman Phillip Minsky, has thoroughly elaborated on particular phases leading up to financial instability, therefore outlining the traditional pattern of an economic bubble. In his famous book 'Stabilizing an Unstable Economy,' he has distinguished five subsequent stages of this phenomenon: displacement, boom, euphoria, profit-taking, and panic.
Displacement refers to the moment when investors become enamored by a novel paradigm – a trailblazing technology or exceptionally favorable economic circumstances (for example, the interest rate on mortgages reaching its historic low prior to the housing bubble). Later, the rise in prices begins to accelerate due to the prevalent media presence of this topic, effectively disguising the situation as the 'once-in-a-lifetime' occasion during the phase of boom. And from that moment on, it is relatively easy for the entire market to lose touch with reality and indulge in a whirlpool of economic excitement. The euphoria stage is characterized by skyrocketing prices, reaching all-time highs due to the faithful application of the 'greater fool theory' - claiming that there will always be buyers willing to pay a higher price, no matter how high. During the profit-taking phase, capital operated by institutional investors, market mavens, funds, and other professionals is being sold due to their suspicions of the impending bubble burst. Even the smallest market event can then prick a bubble, immediately greeting investors with margin calls and plummeting asset values. This portrays the panic phase, in which everyone is highly determined to sell the calamitous asset at any price.
In fact, every bull market, prior to ending, can be characterized by an incredible eye-popping story that people get to believe. In 2008, that was the housing bubble, in the early 2000s – the high-tech bubble. Let's take a closer look at the historical examples of economic bubbles.
Bubbles of the past
The Netherlands has become a home to one of the first documented phenomena of this kind - the Dutch Tulip Bubble. As bulbs of these plants have arrived in Holland in the early 1600s, they have instantly become luxurious goods due to their unusual appearance. Tulips' prices have skyrocketed, exceeding the sums equivalent to the current value of $60 000, eventually crashing in February 1637 with the bulb auctions abandoned by their regular visitors.
Rapid technological progress caused by the Internet's development has resulted in a severe frenzy and excessive speculation of the Internet-related enterprises. By 1999, the tech-heavy NASDAQ Index has doubled, and "in March 2000, the combined value of all technology stocks was higher than the GDP of most nations" (according to the Federal Reserve bank of St. Louis). As the sales growth became the only thing investors heeded, companies focused on it at all costs. Their strategies included excessive marketing spending, commitment to significant acquisitions, adding ".com" to the companies' names to earn their way to the top of consumer awareness, or even going public without a finished product. Yet, investors were entranced by the charm of a domain, neglecting seemingly outdated metrics like profitability and valuation. By the beginning of October 2002, multiple online shopping companies have been forced to experience tremendous losses or even wholly end their economic activity.
Four years later, housing prices in the United States have peaked due to predatory private mortgage lending and lack of proper market regulations. As house prices began to decline in 2006 and 2007, the evident burst of the housing bubble in 2008 has significantly contributed to the worst financial crisis experienced since the Great Depression.
What causes economic bubbles to burst?
Obviously, nothing lasts forever, even the economic bubbles.
Eventually, they burst, severely harming the markers and people's pockets. Why does it happen? "In the end, of course, all violations of the fundamental laws of economic and financial common sense are paid for; but every bull thinks he will unload before the break," as Edwin Lefevre explained.
The extensive damage caused by bursting a market bubble is directly tied to the particular sectors involved in this occurrence and the level of their participation in the phenomenon. For instance, the bursting of the Japanese real estate bubble of 1989-1992 has fueled a prolonged stagnation period in Japan, which is why the 1990s are proclaimed by many as the 'Lost Decade' for the Japanese economy. The renowned Canadian American economist John Kenneth Galbraith once said: "It is easy enough to burst a bubble. To incise it with a needle so that it subsides gradually is an operation of undoubted delicacy." Yet, it is not a trivial task – according to his later observations: "once a boom is well started, it cannot be arrested. It can only be collapsed."
Are we experiencing a bubble right now?
These days, we can witness a fierce battle between sophisticated multi-billion-dollar hedge funds and thousands of individual day traders, who – acting as a crowd – start conquering their mighty opponents. As you might have heard in the recent news, they have significantly raised the price of GameStop shares (an American gaming retailer whose sales have been substantially suffering due to the pandemic). Apparently, it is not just the GameStop that Wall Streets is worried about. Other money-losing companies have also surged recently, with their prices quickly pushed up by the investors despite the risks accompanying these investments.
Can we protect ourselves from economic bubbles?
As many economists claim, the presence of speculative bubbles in the free-market economy is inevitable. The nature of these phenomena tends to be highly deceptive and unpredictable since they are mainly tied to the specific stock exchange reality, so well described by a successful businessman, William Feather: "One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute." Nonetheless, the primary understanding of the chief mechanisms inducing economic bubbles, as well as the knowledge enabling to discern their main symptoms, might save not only thousands of dollars but also a generous dose of one's peace of mind.
At the end of the day, we should certainly hold onto the words of the legendary investor, Sir John Templeton: "The four most expensive words in the English language are: 'This time it's different.'" With that in mind, watch out for the next waves of excessive market enthusiasm and stay safe! :)
Commentaires