In this infographic, we discuss bubbles, not the kind that you buy at the dollar store, mind you, but the kind that can lose millions of dollars in asset value, and even crash entire economies.
As money and trading have become more sophisticated over time, we’ve run into some economic bumps in the road, called bubbles. Bubbles are also known as Economic Bubbles or Asset Bubbles, and they are situations where an asset is at a price range that strongly exceeds the asset’s intrinsic value. A bubble is an economic cycle characterized by rapid escalation of asset prices, followed by a large drop in price (when the bubble pops or bursts). Bubbles are often conclusively identified only in retrospect, once a sudden drop in prices has occurred.
So what causes bubbles? More recent theories on asset bubble formation suggest that they are likely sociologically driven events. While there is no clear agreement on what causes bubbles, there is evidence to suggest that they are not caused by bounded rationality or assumptions about the irrationality of others.
A few of the factors that drive bubbles include:
- Liquidity Factors – excessive monetary liquidity in the financial system can make markets vulnerable to volatile asset price inflation caused by short-term leveraged speculation.
- Extrapolation – investors tend to extrapolate past extraordinary returns on investments of certain assets into the future.
- Social Herding – investors tend to buy or sell in the direction of the market trend, creating herd behavior which creates a self-fulfilling prophecy that leads to the bubble.
- Moral Hazard – a moral hazard occurs when someone increases their exposure to risk when insured.
The first major bubble in history is known as “Tulip Mania”, which lasted from the 1620s until 1637. It was a period in the Dutch Golden Age during which contract prices for some bulbs of the recently introduced and fashionable tulip reached extraordinary high levels and then dramatically collapsed in February of 1637. The top value during the time for a single bulb of the Viceroy Tulip could reach approximately 25,000 Euros. The effects on the economy were very little. Tulip Mania had no critical influence on the prosperity of the Dutch Republic. However, tulip prices after the bubble burst became equal to regular flowers or onions.
The “Dot-Com Bubble” is another famous, and more recent bubble, that occurred between the 1990’s to 2001. The dot-com bubble was a historic economic bubble and a period of excessive speculation of the extreme growth in the usage and adaptation of the Internet by businesses and consumers. During this period, many Internet-based companies, commonly referred to as dot-coms came on the scene. The top value of the NASDAQ stock market index during this time reached $5,046.86 at its highest. This bubble had a fairly significant effect on the economy, causing a mild recession set within the United States and other foreign nations. Sell offs and subsequent fall in stock prices occurred, and a significant amount of the funds invested were lost. More than $4-6 Trillion dollars was lost due to stock price drops.
“The South Sea Bubble” lasted from 1711 until 1720. At that time, stocks in the South Sea Company were traded for 1,000 British Pounds each, and attracted a lot of people to invest in the South Sea Company. Then the stock prices reduced to nothing by the later half of 1720. The top value of the South Sea Company’s stocks reached 1,000 British Pounds per stock at that time. When it crashed, there was a significant effect on the economy, as a massive amount of money was lost, and the British government took actions to stabilize the banking industry. Stocks for the South Sea Company became worthless.
“The U.S. Housing Bubble” occurred between 2007 and 2009, when rising home prices led to rampant real estate speculation, and also fueled excessive consumer spending on house mortgages. It’s estimated that 56% of home purchases during that period were made by people who would not have been able to afford them under normal lending requirements. Average housing prices during this time reached more than $275,000 due to the bubble. The effects of this bubble were huge! A lot of people lost their houses due to the inability to pay their mortgages. This bubble had close relations with the Global Financial Crises, and has long been thought by many to have helped trigger it, though there were other factors involved as well. U.S. housing prices dropped 25.9%, leaving 13% of houses in the US empty due to inabilities to pay the mortgages.
The subject of much debate as of recently, is yet to be established or not as “The Cryptocurrency Bubble” – yet to be established because it hasn’t exactly burst yet. If it is a bubble, it started somewhere around 2010, and could continue for an unknown period of time. Some say it’s a bubble, while others say it’s the natural result of price discovery with new innovations and adoption. Either way, traditional cryptocurrencies themselves are extremely volatile anyways, much more so than any other asset. Cryptocurrencies are digital assets designed to work as mediums of exchange that use cryptography to secure their transactions, to control the creation of additional units, and to verify the transfer of assets. The total market cap for cryptocurrencies has reached more than $373 Billion. Cryptocurrencies have dramatically risen in value over the period of last year. For example, as the market valuation of the total stock of bitcoins approached US $1 Billion, some commentators have called Bitcoin prices a bubble, while others have disagreed. In 2011, the value of one bitcoin rapidly rose from about $0.30 to $32.00. As of August 2014 it was just under $600. As of December 2017, the value of one bitcoin reached over $16,845 (and over). The price dropped to $7,900 in the beginning of February. What will happen next? The supposed crypto bubble will likely pop at some point, if it is a bubble, leaving some people with huge losses. However, the blockchain technology behind cryptocurrencies will likely continue to provide value as a hidden infrastructure underlying future applications.
How can you identify a bubble? Here’s a few things to look for:
- Rationalizing decisions based on speculated price increases
- Rationalizing asset prices by increasingly weaker arguments
- Incentives for behaving irrationally by economic actors
- A high presence of marketing/media coverage
- Higher risk lending and borrowing behavior
- Unusual changes in single measures
- A lower interest rate environment
- Leverage to purchase assets
- Trade imbalances
Bubbles will come with our modern and imperfect financial system. They have the potential for some to see large gains, and for others to see huge losses. They can occur through innovation or through negligence, and they can have impacts as small as the asset itself, or as large as entire economies.
Enjoy the infographic below,
The Cyberius team