Price Bubble

A situation where an asset or a commodity gets inflated because of overbuying

A price bubble is generally an inflated situation where an asset or a commodity gets inflated because of overbuying and is overheated to an extent where it is not sustainable anymore.

Price Bubble

When investors and others realize the price bubble, that particular commodity's price slumps or crashes due to the panic selling and emergency outflow of funds. 

In the case of an economy, this happens when the stock markets and other financial indicators are rising at rapid rates. Still, at the same time, the GDP and other economic indicators are not giving any booming signals. 

This creates a contradictory situation which eventually causes the bubble to crash.

Some of the most famous examples of a bubble are the Great Financial Crisis of 2008 and the Dot Com Bubble of 2001.

Generally, recessions are caused by a 'bubble.' For example, a sudden significant increase in the demand for a commodity causes a sharp rise in the price of that commodity. This is known as a bubble.

Over time when the price becomes unsustainable for the consumers, demand starts to fall with increasing supply due to high producer surplus. As a result, people stop buying the commodity because of future expectations of further decline in prices.

Inflation

It slows down the business for that commodity until the market revives itself over a long period. This is known as a 'bubble burst.'

The 2008 crisis was caused by a bubble in the US housing market. Demand for housing overtook the supply, which caused exorbitant prices for owning a house. When the bubble burst in 2008, it caused huge repercussions all over the globe.

We have also seen the recent case of Gamestop and AMC stocks which have shot up because of the overbuying by retail investors. It is also an example of a price bubble.

How does a Price Bubble work?

In some cases, a bubble is a cyclical phenomenon; in some cases, a bubble is formed once in a lifetime and then deflates to an unsustainable level.

A bubble is a rise in the value of an asset to an extent where it surpasses its intrinsic value. The new valuation is not fundamentally justifiable but keeps increasing because of the market effect.

Massive increase

The main forces driving a price bubble are future expectations and market sentiments. In addition, a bubble can keep inflating itself, meaning that the speed it increases is proportional to its duration.

It is also true that all overpriced assets are not causing a bubble. Some assets have a future growth potential higher than their current intrinsic value, so they tend to be more expensive than their fundamentals show, which is okay.

A bubble defies general observations of market mechanisms; that's how one identifies a bubble. So, for example, during the subprime mortgage crisis, the real estate prices didn't make sense because they were highly overpriced and defied all other previous observations back then.

A bubble does not pose any threat to anyone. On the contrary, it benefits the free riders who tend to jump on the inflationary bubble curve, which goes up sharply in a short period.

The problem occurs when the bubble reaches its saturation point. When the sustainability of a bubble is doubtful, big investors tend to exit the asset quickly, creating a supply for that asset that was almost non-existent in the market.

This happens quickly over a brief period. This induces panic selling in the minds of all the free riders who were on board only for the short-term gains; now, they encash their assets and create more supply.

Seeing this, everybody panics because it drives the asset price down rapidly. The nationwide selling of that asset then follows this. The same highly overpriced asset is now losing value, like running water.

Overpriced assets

The sufferers here are the long-term everyday retail investors unfamiliar with this. They lose their life savings in just weeks. This ruckus carries on for months and even years.

It also leads to a ripple-down effect and a chain reaction from markets where the market sentiment goes down to an extent where panic selling spreads to other related asset classes.

This leads to a broader economic crash, affecting other macro indicators of the economy significantly. For example, this happened during the 2008 financial crisis and the great depression of 1929.

What is a market crash?

A stock market crash is explained as a sharp decline in the overall stock market of a particular region at a specific given time.

 It is characterized by the following:

  • Period of high uncertainty and 
  • Low public sentiment 
  • It can also trigger panic selling in a market.

Market Crash

It can increase liquidity in the economy as cash is withdrawn from the market. It can also benefit other asset classes like Bonds and commodities like Gold and Silver.

The most notable characteristic of a crash is that it comes at an unanticipated time and it comes suddenly. 

A crash can last from days to weeks to years to even decades!

A crash is followed by a widespread drop in stock prices, falling benchmarks, low confidence in markets, decreasing liquidity, low sentiments, and volatile market disruptions.

A bubble is one of the most frequent causes of a market crash. During Bull runs, markets tend to be overpriced, and if the bull run momentum is significant enough, it can transform into a huge bubble.

The giant loophole in our financial systems has been our inability to successfully predict and determine the possible counter-measures to a financial crisis.

The words' crisis' and 'recession' have a fragile line between them. A financial recession is characterized by a massive decline in production levels in an economy for a sustained period. 

A financial recession that takes place for a prolonged time is known as a 'Depression.' The best example of depression is 'The Great Depression of 1929'. 

A Crisis generally follows a recession or depression. 

A crisis is characterized by a decline in the value of money and purchasing power of consumers, the rising cost of production, and a sharp drop in demand and supply.

There is vast unemployment and distrust for the people in power, increased crime rates, and a decline in quality of living are some of the features of a financial crisis.

Famous Crashes caused by a Bubble

The biggest loophole in our financial systems has been our inability to successfully predict and determine the possible counter-measures to a financial crisis.

 There is a thin line between the word 'crisis' and 'recession.' A financial recession is characterized by a massive decline in the production levels of an economy for a sustained period. 

Famous crash

A financial recession that takes place for a prolonged time is known as a 'Depression.' The best example of depression is 'The Great Depression of 1929'. 

A Crisis generally follows a recession or depression. 

A crisis is characterized by a decline in the value of money and purchasing power of consumers, the rising cost of production, and a sharp drop in demand and supply.

Unemployment, distrust for the people in power, increased crime rates, and a decline in quality of living are some of the features of a financial crisis.

In this section, we will talk about some of the world-famous market crashes, which have served as a sample for future research on crashes. But unfortunately, all our knowledge of crashes is only obtained from these falls.

The Great Financial Crisis of 2008 or The Real Estate Crash

"If you wait till you know everything, it's too late" - Warren Buffet

The 2008 crisis was mainly caused due to the following three reasons:

1. Low rate of borrowing

2. Adjustable Mortgage rates

3. Mortgage-backed securities issued vast amounts by investment banks mainly consist of subprime borrowers.

Financial Crisis

After the 'dot-com crash' of 2000 and the September attacks of 2001, also known as the '9/11 attacks', the Fed lowered interest rates to almost 1% from previous highs of 5-6%, making borrowing drastically cheaper. 

It also nudged the small banks to lend out more loans to revive the economy by increasing the demand for real estate due to the increased money supply just after the recessions, followed by the abovementioned events.

Also, the 'American Dream of owning a house was glorified heavily by politicians and media outlets, so people used the cheap credit to buy homes. 

Adjustable mortgage rates are mortgage rates that adjust depending on the market's prevailing prices. 

These adjustable-rate mortgages were low because of cheap credit, so banks started lending these mortgages to subprime borrowers, known as 'Subprime loans. 

Interest Rates

These sub-loans are given to high-risk borrowers with a much greater chance of defaulting the loan and would not get loans under the regular lending system. 

Small banks started issuing lots of such loans, which were clubbed together to make 'mortgage-backed security. 

These securities were discounted according to their credit ratings and traded by large investment banks. Large institutional banks buy these mortgages, pay a lump sum price at a slight discount, and then receive the mortgage payments from the borrowers over time. 

The problem struck when these large banks started clubbing the high-risk mortgages with the moderate and low-risk mortgages to get a good credit rating, determining the quality of these securities. 

As all the high-risk mortgages received an AAA rating, considered very safe, banks enjoyed good returns on these securities. Moreover, they co-existed in a housing bubble simultaneously because of the cheap credit, which increased demand. 

Housing prices in the US rose sharply, as did the number of low adjustable-interest rate mortgages.

When the prices became too high for consumers to sustain and the Fed raised interest rates, the market borrowing rate increased suddenly, and so did the adjustable-mortgage rates.

Demand for housing decreased, plus the subprime borrowers started defaulting on their mortgages, which reduced their value and significantly questioned their liquidity as no one wanted to repurchase them anymore. 

Globe

This led to a chain of defaults, substantial investment banks started to default on their payments, and many banks could not repay the creditors because of the decrease in value of the mortgage-backed securities. 

This worsened to a point where the fourth largest bank in the USA, Lehman Brothers, a 158-year-old institution with assets worth $600 billion in its peak period, filed for bankruptcy on September 15, 2008, due to decreasing share prices and rising defaults.

The government and other big institutions saved many other banks. For example, bear Stearns was bought by JP Morgan Chase, which incurred huge losses. The demise of Lehman Brothers caused Wall Street to crash. 

This had an impact worldwide as the investment banks had assets and operated internationally.

The dot com bubble of 2001

In the early 1990s, the internet became a massive sensation in the US and the western world. People realized the potential of doing things digitally. Innovations were rapidly increasing such hype amongst the people.

Pop

Seeing this boom, many new startup lovers started launching new companies to capitalize on this opportunity. People bought almost anything which had a dot com in its name.

Furthermore, people started fraudulent activities when they realized they could fool the uneducated and technologically less unaware by creating a fake company to promise high returns and taking their money only to never hear from them again.

There were more Tech startup IPOs in the United States between 1990-2000 than in any other sector combined. As a result, people and investors saw massive gains and two-fold returns in months!

This trend overheated to a level where it formed a bubble so big that when it burst in 2001, the prices of tech stocks lost 90% of their value in a fortnight, and the majority of those new startups were either bankrupt or unsustainable.

Ordinary people and retail investors lost their dear money, and the market took almost 2-3 years to recover from its previous lows. Tech stocks have done better since then, but this crash shows how dangerous a bubble can be.

Key Observations

  • A price bubble is generally an inflated situation where an asset or a commodity gets inflated because of overbuying and is overheated to an extent where it is not sustainable anymore.
  • When investors and others realize this, that particular commodity's price slumps or crashes due to panic selling and emergency outflow of funds. 
  • Over time when the price becomes unsustainable for the consumers, demand starts to fall with increasing supply due to high producer surplus. As a result, people stop buying the commodity because of future expectations of further decreases in prices.
  • A bubble is formed because of a rise in the value of an asset to an extent where it surpasses its intrinsic value. The new valuation is not fundamentally justifiable but keeps increasing because of the market effect.
  • It is also true that all overpriced assets are not causing a bubble. Some assets have future growth potential, which is higher than their current intrinsic value, so they tend to be more expensive than what their fundamentals show, which is okay.
  • It also leads to a ripple down effect and a chain reaction from markets where the market sentiment goes down to an extent where panic selling spreads to other related asset classes.

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Researched and authored by Aditya Murarka | LinkedIn

Reviewed and Edited by Sakshi Uradi | LinkedIn

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