BAJAJ BROKING
March 18, 2025
8 mins read
In an economic bubble, asset prices increase rapidly – a phase known as fast inflation. Then, there is a quick decline in their prices, which is when the bubble bursts. Read more..
Typically, in an economic bubble, assets trade at prices much higher than their intrinsic value. In other words, the price of assets is not in line with their fundamentals. This can happen due to multiple reasons.
One, there could be a lot of exuberance in the market, which causes many investors to buy securities, driving up their prices. Two, there could be an increase in the money supply. As more money chases assets, their prices rise. Read less
An economic bubble can be caused by numerous reasons. Typically, in a boom phase, companies find it easier to grow. As they grow, they can pay higher salaries to their employees. With higher disposable incomes, people begin investing in various kinds of assets. Besides, there is a general sense of euphoria. Hence, even if prices are high, people still invest in assets because they have high disposable incomes.
In a boom phase, most businesses and people perform well. Hence, there is a lot of money in the system. Besides, borrowers are able to pay their loans easily for the most part. Hence, lending rates fall. As lending rates fall, people can borrow cheaply to invest in assets, which also drives up their prices.
To put it simply, when an economy goes through a boom period, it is easier to make money, which results in a sense of positivity and euphoria. This is fine to an extent. However, when people start chasing assets excessively in such a manner that their prices do not have much to do with their fundamentals, it results in an economic bubble.
It is important to understand the various stages of an economic bubble to understand this concept thoroughly. So, please find the stages below:
Displacement: This stage witnesses the emergence of a new trend or technology in the market. As a result, investors start getting obsessed with a new trend and they stop paying attention to the standard rules of trading. For example, when interest rates on housing loans fall, a lot of people start taking loans to purchase real estate without considering the possibility of interest rates rising in the future.
Boom: In this phase, prices increase slowly in the beginning after a displacement. However, soon, they gain momentum as more people start buying an asset. The asset in question becomes more popular and gets widespread media coverage. Many investors start fearing that they will miss out on a huge opportunity if they do not invest in the asset. So, a significant number of investors start putting their money into the asset.
Euphoria: This phase is characterized by an uncontrollable rise in asset prices. Investors and traders stop being cautious about valuations. In fact, they start justifying extremely high valuations, citing one indicator or another. Even if someone tells them to be cautious, they feel that they will be able to sell their assets, no matter how high their prices are.
Profit-taking: In this phase, certain smart investors sell their assets after paying attention to warning signs. That said, it remains extremely difficult to predict when a bubble will burst because markets can remain irrational for a very long period. Hence, while some investors sell their positions, a lot of them stay invested, as there is no clarity on when a bubble will burst.
Panic: This is the final stage, wherein panic sets in. However, it usually takes a minor event to start bursting an economic bubble. When the panic sets in, asset prices start falling as rapidly as they had increased. Investors, especially those facing margin calls, want to move out of their positions regardless of the level of prices, eventually incurring considerable losses.
You can find an economic bubble in various asset classes. Hence, it is really important to understand the main types of bubbles, which are explained below:
Bubble in a share market: In this type of bubble, stock prices rise well and beyond their true (intrinsic) value. This is because investors are willing to pay a much higher price for stocks than they are worth. Investors can use technical and fundamental indicators to spot the signs of a bubble.
Bubble in commodities: Such bubbles are formed when commodities like gold, oil, or metals witness a huge jump in their price due to reasons like supply shortages, geopolitical issues, etc.
Credit bubble: This bubble is often caused when lenders offer low interest rates or favourable terms, which makes borrowers borrow more than what is sustainable. Then, there comes a stage when borrowers find it impossible to repay their loans. This is where the bubble begins to burst.
Market bubble: When a bubble spreads beyond the share market and starts affecting other sectors, like real estate, it is called a market bubble. In the case of a real estate bubble, property prices rise rapidly, as people are willing to pay a lot to buy residential and commercial space.
The following historical examples can help you improve your understanding of economic bubbles:
Housing bubble in the US: Due to interest rate cuts by the US Federal Reserve, many individuals with bad credit history started getting credit to buy homes in the early 2000s. Meanwhile, banks converted such risky mortgages into securities and sold them to investors. Ultimately, when interest rates started to increase, many borrowers found it very tough to repay their loans, causing defaults.
The Dot-com bubble: As the Internet emerged as a prominent technology in the late 1990s, investments in Internet-related businesses also soared. Consequently, stock prices of several companies went through the roof. But, at some point, investors started selling their stock holdings. As a result, stock prices fell, which ended the bubble and caused a significant turmoil in the stock market.
Stock market and real estate bubble in Japan: Sometimes economic bubbles are caused by monetary policy. Take the case of the Japanese economic bubble of the 1980s. As the yen increased by 50% in the early 1980s, the Japanese economy went into a recession. To address it, the Japanese government launched monetary and fiscal programs. Due to these programs, the value of Japanese stocks and urban land trebled between the mid to late 1980s. However, the bubble burst in 1991, making it very difficult for the Japanese economy to grow.
As discussed, economic bubbles first cause the prices of assets, like shares or real-estate, to rise beyond their fundamentals and later cause the prices to crash. Hence, bubbles can have a considerable impact on investments.
Often, investors think that bubbles provide them a great opportunity to make a quick buck. Many investors start buying an asset when its price is already high. However, when the price starts falling, they make huge losses. This is often the case with investors who invest very late when the market is at its peak.
At times, investors incur such huge losses due to a bubble that they lose their confidence in the market. As a result, some of them invest only in fixed-interest investment products for the rest of their lives.
Hence, it is extremely important for investors to be cautious of economic bubbles. Instead of chasing assets with inflated prices during a bubble, they should adopt a structured approach to investing.
They should not get over-excited seeing asset prices soar. Rather, they should invest for an objective, like purchasing a house or funding the education of their children.
Rapidly rising prices of assets, which seem to be not in line with their fundamentals, could be a sign of an economic bubble. For example, you may notice that the stock price of certain companies is increasing at a much higher rate than their earnings or cash flows.
Upon further investigation, you realise that analysts do not expect these companies to grow at a high rate in the future. Hence, you can conclude that there seems to be a bubble in their prices.
Another indicator of a bubble is excessive speculation. At times, there is so much buzz about an asset that you can see people talking about it in cafes, restaurants, offices, malls, and living rooms. This shows that investors are over excited about an asset. They get obsessed with the idea of rising prices and ignore fundamentals, which indicates a possibility of a bubble.
At times, a number of new or inexperienced investors start buying an asset after listening to experienced investors. Such new participants often do not understand the asset they invest in; however, their money ends up causing a lot of speculation in the market, causing a bubble.
Whether you are a new or a seasoned investor, you can follow these strategies to protect your investments during economic bubbles:
Follow the fundamentals: You should follow the fundamentals of assets in which you are keen to invest. If you want to invest in companies, you must analyse their financials and see how their profits and cashflows are growing. You must stick to fundamentals and avoid investing in an asset purely based on its price.
Portfolio diversification: You need to spread your investments across several asset classes and markets. Even if one of these asset classes or markets witnesses a bubble, it is possible that other asset classes or markets may not face a decline, thereby lowering your portfolio risk.
Do not rely on borrowed funds much: If you rely too much on borrowings, your trading can be unsustainable. Borrowings can magnify your losses when the market begins to fall. Hence, you should not borrow too much to protect against an economic bubble.
Stay away from speculation: A lot of people have a tendency to speculate, which peaks during the formation of a bubble, eventually causing them huge losses. Hence, you should stay away from speculation.
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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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When a rise in asset prices cannot be explained by fundamentals, it hints at an economic bubble. During such a phase, many investors stop focusing on fundamentals and they get obsessed with the idea of becoming rich quickly.
First, economic bubbles cause stock prices to rise considerably. Then, they result in a massive crash in stock prices, causing many investors to report huge losses.
As markets can remain irrational for a very long period, it is often difficult to predict economic bubbles. However, certain signs like extremely high valuations, excessive borrowings, and a general sense of euphoria may indicate a bubble.
When investors suspect a bubble is forming, they should stay away from speculation, invest for the long run, not rely too much on borrowed funds, and do their own research.
An economic bubble can cause asset prices to fall for a long period of time. However, market corrections often cause prices to fall for a short period. A bubble is a result of massive speculation, which shows that something is very wrong with asset prices. However, market corrections are not necessarily a result of massive speculation.
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