In the finance world, an economic bubble is a market phenomenon characterized by surges in asset prices to levels significantly above the fundamental value of that asset. Bubbles are often hard to detect in real time because there is disagreement over the fundamental value of the asset.
Bubbles form in economies, securities, stock markets and business sectors because of a change in investor behavior. This can be a real change, as occurred in the bubble economy of Japan in the 1980s when banks were partially deregulated, or a paradigm shift, as happened during the dot-com boom in the late 1990s and early 2000s. During the boom, people bought tech stocks at high prices, believing they could sell them at a higher price until confidence was lost and a large market correction, or crash, occurred. Bubbles in equities markets and economies cause resources to be transferred to areas of rapid growth. At the end of a bubble, resources are moved again, causing prices to deflate.
A bubble company is a company whose valuation greatly exceeds that suggested by its fundamentals. The first well-documented bubble company was the South Sea Company, which caused the South Sea Bubble in 1720 (see below). A bubble company arises when speculators continuously buy up the stock in expectation of increased future earnings. However, bubble company shares often become worthless once the speculative bubble bursts.
One common characteristic of a bubble company is scandal. For example, during the dotcom bubble many internet-based firms traded at high multiples under the expectation of generating high levels of future growth. When earnings did not meet analysts’ expectations, many firms began to cook the books in order to manipulate their bottom lines. Once the internet bubble burst, the individual bubble companies either went bankrupt or experienced massive drops in their share prices.
The bubble theory is a financial school of thought that believes in the development of bubbles: a rapid rise in the market prices of an asset class, far above its true values, that is identifiable by its feverish nature – an irrational exuberance, as former Federal Reserve Chairman Alan Greenspan famously characterized it. Under the bubble theory, large overvaluations of assets can persist for years, but eventually burst, causing prices to precipitously decline before stabilizing at more reasonable levels.
Bubbles can develop in securities, commodities, industries, stock markets, housing markets, and other economic sectors whenever something causes investors to eagerly pursue profits beyond a reasonable hope of return.
In the simplest terms, a bubble is an overheated market in which there are too many buyers who are too keen to buy. As a result, prices rise way too fast, and this situation becomes unsustainable. Eventually, some people realize this and start to sell out. The whole process goes into reverse equally rapidly, and the bubble bursts, with people selling in panic so that prices plunge. Those who entered the market late in the process suffer substantial losses in particular.
A housing bubble is a run-up in housing prices fueled by demand, speculation and exuberance. Housing bubbles usually start with an increase in demand, in the face of limited supply, which takes a relatively long period of time to replenish and increase. Speculators enter the market, further driving demand. At some point, demand decreases or stagnates at the same time supply increases, resulting in a sharp drop in prices — and the bubble bursts.
A financial bubble refers to a situation where there is a relatively high level of trading activity on a particular asset class at price levels that are significantly higher than their intrinsic values. In other words, a bubble occurs when certain investments are bid up to prices that are far too high to be sustainable in the long run.
Traditionally, housing markets are not as prone to bubbles as other financial markets due to large transaction and carrying costs associated with owning a house. However, a combination of very low interest rates and a loosening of credit underwriting standards can bring borrowers into the market, fueling demand. A rise in interest rates and a tightening of credit standards can lessen demand, causing the housing bubble to burst.
An echo bubble is a post-bubble rally that becomes another, smaller bubble. The echo bubble usually occurs in the sector in which the preceding bubble was most prominent, but the echo is less dramatic.
People point to the rally that occurred after the market crash of 1929 as an example of an echo bubble. Just like its more prominent predecessor, the smaller echo bubble eventually burst. Also, after the technology bubble that occurred at the turn of the 21st century – one of the biggest bubbles of all time – people believed that another echo bubble was on the way.
An Internet bubble is a rapid rise in equity markets caused by speculation into online-based companies (referred to as dotcoms).
The internet bubble of the late-1990s is often considered a benchmark case of investors abandoning fundamentals in their search for the next big thing. As consumers flocked to the internet, investors were afraid that not becoming involved would be a huge missed opportunity. Venture capital companies and speculators poured money into internet startups during the 1990s in the hope that those companies would one day become profitable.
The internet bubble of the 1990s burst after more than five years of steady market growth, peaking on March 10, 2000. The collapse of many startup internet companies, along with several interest rate increases by the Federal Reserve, led to an economic recession precipitated by a rapid decline in the Nasdaq.
Standard of Living Bubble
The standard of living bubble is the concept of consumers living beyond their means for an extended period of time. The notion of a standard of living bubble is characterized by flat inflation-adjusted earnings for members of the workforce over several years, during which the use of consumer credit and spending increases in order to provide the illusion of increases in standard of living.
The standard of living bubble refers to consumers relying on credit to feel rich, instead of relying on increased real wages, which simply did not occur. Some have characterized the western economies as having this type of consumer credit bubble, as in years, such as 2005; the average personal savings rate for Americans was negative. This meant that the average American was actually saving a negative amount of money over the course of the year, i.e. spending more than they earned.
South Sea Bubble
The south sea bubble was one of the largest stock scams of all time. The U.K.-based South Sea Company’s shares saw a huge appreciation based on rumor, speculation and false claims before plummeting and eventually becoming worthless. Thousands of people lost their life savings.
The scam occurred in 1720, when South Sea’s stock soared in the wake of speculation and greed surrounding the monopoly the South Sea Company was perceived to have in the shipping and trade industries, particularly in Mexico and parts of South America.
With nothing to prevent it from doing otherwise, South Sea Company’s management continued to issue shares in response to seemingly insatiable demand. As a result, the stock’s price soared, defying all fundamental sense. Eventually, the truth was exposed: the company was making virtually no profit, and the share price plummeted when investors fled. In the post-Enron investing world, some have dubbed this scam the Enron of England.
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