A financial bubble can be fun until it pops. See what an economic bubble is and its impact on the market.
Since we were children, we heard the word “bubble,” like in soap bubbles, or bubbly water. But we never thought there might be another type of bubble – the financial bubble. Of course, as time went by, we may have heard or even learned about the financial bubble. Both for those who want to study and those who wish to deepen their knowledge, we will talk about this bubble in today's article.
So, let’s dive in!
What’s a financial bubble?
According to NASDAQ, an economic bubble is: “a market phenomenon characterized by surges in asset prices to levels significantly above the fundamental value of that asset.”
An exuberant market reaction usually drives the bubble through some stages. Let’s see:
The five stages of a bubble
1. Displacement – the moment when investors notice a new product, asset, or historically low-interest rates. During this stage, a trading opportunity rises in at least one sector of the economy.
2. Boom – the moment when the price gains momentum and starts to rise as more investors are drawn to the respective asset. During this stage, investors are willing to take risky loans as economic prospects improve.
3. Euphoria – when the asset price hastens, at this moment, investors believe that the price will keep on rising and think that they can sell before implosion.
4. Distress – the moment when an event - such as rumors, a change in government policy, a war -causes a decline in investor's confidence, and the price takes a breather.
5. Blow-off – the asset price drops just as fast as it increased. It is the moment when supply overcomes demand as investors want to liquidate at any price.
There are two major types of bubbles: the equity bubble and the debt bubble.
The equity bubble – is tangible, characterized by easy liquidity and real assets. To better understand it, read about Tulip Mania, and the Dotcom bubbles.
The debt bubble – is credit-based, and real assets do not support it. These types of bubbles end in deflation and can cause a currency crisis. See below, the US Housing Bubble.
Examples of bubbles
Like everything else in the world, the bubble phenomenon had a beginning. The oldest economic bubble happened in the early 1600s, and the most recent one took place in 2009. We will see what happened in the 1600s and 2009, and everything in between.
A. The Dutch Tulip Bubble (Tulip Mania)
The Tulip Mania took place in 1630 in Holland, and it is the oldest economic bubble on record. When the tulip bulbs were brought from Constantinople to be studied, some people stole them and started trading them. The bulbs were treated as luxury goods since they were hard to find.
As demand surged, so did prices. Between November 1636 and early 1637, the bulbs' price rose twentyfold. At its peak, the bulbs were more expensive than a house. A missed deal between a buyer and a seller made the bubble burst. The price plummeted 99% by May 1637.
To disperse the panic caused by the dramatic drop in price, Dutch authorities allowed contract holders to be freed from the deal if they paid 10% of the contract value.
B. The South Sea Bubble
In 1711 the South Sea Company was founded, and at that time, the British government promised the Company a monopoly on the transactions with the Spanish colonies in Latin America. The South Sea Company was looking to have the same success as the East India Company had. This goal made investors snap up shares of the South Sea Company.
Despite the entire lobby that the directors made and the eightfold surge in share price to £1050 in 1720, the Company collapsed. An investigation ordered by the House of Commons showed that more than three ministers took bribes and speculated on the price.
Due to financial difficulties and its tinted reputation, the Company sold most of its rights to Spain in 1750.
C. Japan’s Real Estate and Stock Market Bubble
This bubble set the stage for the Lost Decade – the most protracted economic crises ever recorded. It all took place in the 1980s when the Japanese government released a monetary and fiscal stimulus program to keep the recession under control. The 1986 recession was caused by a 50% surge in the Yen.
The measures taken by the government were such a success that due to market speculation, the Japanese stocks and the real estate located in urban areas tripled in price between 1985 and 1989.
In 1989 the real estate bubble was at its peak, and during that time, the value of the Imperial Palace land was higher than the entire California real estate market.
The bubble popped in 1991, marking the beginning of deflation and economic stagnation – the before mentioned Last Decade.
D. The Dotcom Bubble (The Internet Bubble)
This US-based bubble marked the rapid rise in internet popularity in 1990. During those times, hundreds of dotcom companies gained billions of dollars through their IPOs, as they set the scene for the "new economy."
TECH100, the index made up of technology companies, has snowballed between 1990 and March 2000. From a level below 500, it exceeded 5,000 at its peak in 2000. However, by October 2002, it plummeted by 80%, which caused the US to enter a recession.
E. The US Housing Bubble (The Real Estate Bubble)
Various experts believe that the Dotcom Bubble blow-off made investors consider real estate a safe asset, which led to the Real Estate Bubble.
This bubble took place in the mid-2000s and impacted more than half of the United States. As a result of the Dotcom bubble, the market started to crash, and investors turned to real estate. Both the value and the demand for homeownership began to increase.
Encouraged by the government, banks kept on lowering their interest rates and reduced their requirements for credits. The preferred type of mortgage became the adjustable-rate mortgage (ARM), which had low introductory rates. It gave people the possibility of refinancing within three years, with a maximum of five years.
Despite this, the market began to rise again, and the interest rates to increase. So, with rising interest rates, the ARM refinancing was done at higher rates.
Soon, it was evident that the home values could drop and cause a crash in prices. The collision took place, and billions of dollars have been lost in mortgage defaults.
The effects of the bubble
Although a bubble leaves behind dramatic repercussions, there is also a bright side to it. The pop leaves room for technological improvements or new infrastructure that otherwise might not have received funding. Even though every bubble is different, it is essential to understand that the bigger it is, the more intense its effects are.
For example, the Dotcom Bubble had lasting benefits. Both during and after it, the foundations of the internet that we use nowadays have been laid. We are now taking advantage of something that happened two decades ago.
If you’ve read this far, then take a look at the other featured articles, and market news. Maybe you will learn new things. If you find words that you don't understand, check-out our financial dictionary.
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Sources: nasdaq.com, investopedia.com, Britannica.com, weforum.org
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