What goes up, must come down: An analysis of market bubbles

What goes up, must come down: An analysis of market bubbles

What are they?

Market bubbles (or asset bubbles) are a type of economic cycle in which the market value of an asset rises significantly above their fundamental value due to high levels of speculative trading. This inflated value of the asset is short-lived, and the value of the asset will typically fall faster than it initially rose when the bubble finally deflates or ‘bursts’. Bubbles can theoretically develop in any asset class, given that there is sufficient interest from both buyers and sellers. Notable bubbles in history have occurred in the markets for minerals, stocks, real estate and tulips.

The US housing market was a particularly noteworthy bubble in the early 2000s. The bubble ‘burst’ in 2007 and the contraction in house prices created an avalanche of flow-on effects, ultimately leading to what we now call the Global Financial Crisis.

Stages of a bubble

A standard market bubble model by Hyman Minsky suggests that there are five stages in a bubble. These stages (in order) are displacement, boom, euphoria, sell-off and panic stages.[1]

For a bubble to emerge, a catalyst or new development is required. At this point, a common factor attracts the attention of investors and can include (but is not limited to) emerging technology, political/legal changes or favourable economic conditions.[2] This critical point which kick-starts a bubble is the displacement phase.

If enough investors are attracted to the asset, the market becomes flooded with buyers and demand for the asset rises. This is the boom stage, and asset prices begin to skyrocket as a result. At this stage, investors may borrow money to purchase assets, further increasing the size of the bubble (although it is only after the bubble ‘bursts’ which most investors become aware of this). Lenders may  adopt riskier lending practices to increase profits by lending money to high-risk individuals with the hope of generating higher returns through increased interest payments.

The euphoria phase is next, and it is where rationality is replaced with greed. Media attention focuses on the market in question, and outsiders see an opportunity for easy money by buying the asset and quickly selling it off as prices continue to rise.

The sell-off phase begins when the market has lost its upward momentum, possibly because of the emergence of new information or changing market conditions. Prices begin to decline as some investors lose confidence in the underlying asset and sell their holdings.[3]

The final phase is a state of panic; the market is flooded with investors who want to sell at any price, fearing the asset will soon become worthless. The supply of the asset far exceeds the demand for the asset, and prices plummet.

What else can explain the sharp rise in asset prices?

There is no single reason as to why bubbles form, but it always involves investors ignoring (or being unaware of) the warning signs. Bubbles have been observed in newer markets because investors have no reference prices of similar, more established assets to compare to (because the new assets are the only one of their kind).[4] Such examples of bubbles in new markets occurred in the markets for Bitcoin (2017) and technology stocks during the dot-com bubble (2000).[5][6]

The greater fool theory (that there is always a potential upside as long you can pass your assets onto a ‘greater fool’) is a common explanation. It proposes that bubbles continue to inflate until the final buyer cannot find another one.

For data-savvy investors who project recent high returns into the future (extrapolation), may end up expecting the future returns to match the past. This creates an illusion of the actual market returns and gives a false sense of optimism because markets may, in fact, already be at their peak.

Case study: The US housing market bubble

Figure 1: Supply of houses in the US since 1980

Figure 1 shows how many months’ supply of houses are on the market, given that no additional houses will be added to the market (total houses for sale divided by total houses sold). The greater the demand, the fewer months’ supply of housing will be available in the market. Between 1998 and 2006, demand for new houses reached extraordinarily high levels not seen since the 1970s (the boom and euphoria phases).[7]

Figure 2: Median sales price for new houses in the US since 1980

However, rising interest rates combined with lax lending practices (such as lenders granting loans to homebuyers who could not meet the repayments) caused many homebuyers to default on their debt payments. This dramatically increased the housing supply from 2006 – 2009 because houses that were defaulted on were simultaneously put on the market (the sell-off phase). [8] There were also very few buyers in the housing market due to a lack of confidence in real estate as a worthwhile investment, further lowering the cost of houses. The value of an average new house fell nearly $60 000 (about 22%) from its peak when the US housing bubble deflated in 2007 and it took seven years to regain the value lost from the height of the bubble (illustrated in Figure 2).[9] The deflation of the US housing bubble is believed to be what initially triggered the Global Financial Crisis[10].

Concluding remarks

The US housing bubble showed that even a small decline in the value of a domestic asset when a bubble ‘bursts’ can  create widespread economic shocks, even internationally. It is surprising to see that, regarding market bubbles, history repeats itself. Bubbles have still been appearing in recent years, despite a large number of past observations. It seems that market bubbles will continue to develop, as long as greed is a fundamental human trait.

[1] Kenton, W. (2020). Bubble. Investopedia. Retrieved 6 May 2020, from https://www.investopedia.com/terms/b/bubble.asp.

[2] The Anatomy of a Bubble – Variant Perception. Variant Perception. (2017). Retrieved 9 May 2020, from https://www.variantperception.com/2017/09/22/the-anatomy-of-a-bubble/.

[3] Stages in a Bubble. The Geography of Transport Systems. (2020). Retrieved 13 May 2020, from https://transportgeography.org/?page_id=9035.

[4] Kohler, A. (2019). It’s Your Money (p. 169). Schwartz Publishing Pty, Limited.

[5] Minenna, M. (2019). The Burst of the Bitcoin Bubble: An Autopsy. Cointelegraph. Retrieved 13 May 2020, from https://cointelegraph.com/news/the-burst-of-the-bitcoin-bubble-an-autopsy.

[6] McCullough, B. (2018). An eye-opening look at the dot-com bubble of 2000 — and how it shapes our lives today. ideas.ted.com. Retrieved 13 May 2020, from https://ideas.ted.com/an-eye-opening-look-at-the-dot-com-bubble-of-2000-and-how-it-shapes-our-lives-today/.

[7] Monthly Supply of Houses in the United States. Fred.stlouisfed.org. (2020). Retrieved 10 May 2020, from https://fred.stlouisfed.org/series/MSACSR.

[8] Chin, B. (2007). What’s a Minsky moment?. Seattle Post-Intelligencer. Retrieved 9 May 2020, from https://blog.seattlepi.com/buzz/2007/08/18/whats-a-minsky-moment/.

[9] Median Sales Price for New Houses Sold in the United States. Fred.stlouisfed.org. (2020). Retrieved 10 May 2020, from https://fred.stlouisfed.org/series/MSPNHSUS.

[10] Holt, J. (2009). A Summary of the Primary Causes of the Housing Bubble and the Resulting Credit Crisis: A Non-Technical Paper. Wayback Machine. Retrieved 13 May 2020, from https://web.archive.org/web/20141017015959/http://www.uvu.edu/woodbury/docs/summaryoftheprimarycauseofthehousingbubble.pdf.