Price Bubble

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21 Aug, 2024

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A price bubble is when the price of an asset such as a stock or a commodity is overbought, or the demand for the same is constantly increasing, which leads to price rise, which is beyond the explainable fair value of the asset itself. This situation implies that the asset's value is much lower than its current market price, and holding it will not realize sufficient long-term profit.

What is Price Bubble?

Explanation

For example, suppose the traders and investor community has a lot of faith in the politics of a country. In that case, they may start pouring a lot of money into the company's financial market in the hope of a better and more profitable business environment. This may move the stock market to very high levels. But this needs to be substantiated with an actual increase in the country's production or GDP.

When the divide between the real and the financial economy gets wider and wider, the bubble might erupt. Investment in a country is also an asset, and very high expectations from the currency might not translate into real returns leading to unrealistic inflation in the price of the assets. This is what the phenomenon of bubbles implies.

Price Bubble Examples

Tulipmania: Bubbles have existed in economies in all periods. The Dutch economy saw the bubble related to the tulips they were so proud of back in the day. In the 1600s, they ranked tulips by their color, and therefore higher ranked tulips were priced higher. The seed could bloom into any color, so it could not be predicted which tulip would be produced in higher quantities. People of all income groups became fascinated with the flowers, and therefore the demand rose to very high levels.

This led to a massive increase in the price, but at the end of the day, they were just flowers that were not intrinsically worth things people were ready to offer in exchange, such as silver drinking cups. People even mortgaged their homes for the flowers in expectation of getting the priciest crop and reselling at a profit. As a result, the tulip bulbs exchanged hands more than ten times.

But suddenly, the market crashed in the sense that buyers stopped demanding them. They stopped coming to the tulip bulb auction, which is when it all began. The people in possession of bulbs realized they were worth nothing. Some say the cause for this crash was the spread of the bubonic plague, but no one truly knows what the true reason was.

But bubbles are not the things of the past; as recently as in 2007, we all witnessed the, Housing Bubble, which led to the crash of the stock market all over the world. Basically, there was a chain of events that led to the crash.

There was an unjustified increase in housing prices due to increased speculations. This led to more people demanding mortgages on the homes because they considered houses highly valuable, increasing the lending rate. Further, these mortgages were securitized into MBS and sold off to investors offering higher interest rates than the G-sec. So the demand for these securities also rose.

The entire chain led to excessive speculation and irrational exuberance in the housing sector. As a result, housing loans were not good quality, and borrowers defaulted, which impacted the MBS's returns, leading to a crash.

From these examples, we can derive the various stages of the bubble.

Stages of Price Bubble

#1 - Displacement

This is the stage where the investors see a promising investment avenue due to a change in the investing environment. This could be a new technological innovation or a new political regime, or anything of this sort. This makes the investors hopeful and expects higher returns; they want to grab such opportunities and pour a lot of money into these avenues. If it works well, they will get huge returns, but if it doesn't, they might end up with losses.

#2 - Uptrend or Boom

Once bigger institutional investors start pouring money into a particular sector or economy, the prices of assets and securities related to this sector start rising, initially at a slower pace and later at a higher pace. This is not the phase where the asset prices have drifted too far from the intrinsic value, but it is the phase that starts attracting more and more investors.

#3 - Irrational Exuberance

Boom is followed by the stage when the speculation goes beyond the understandable limits. Investors start believing in the sector and related securities without analyzing the results of the real economy. As a result, the divide between the actual performance of the sector and the financial sector becomes wider and wider, but investors are still hopeful of the sector's performance. This is when the markets start bubbling up.

#4 - Profit-Booking

The institutional investors start realizing that the gap is increasing and start selling their investments to safeguard their profits until the investment is profitable, i.e., until the bubble has not burst. Increased selling starts reducing the price of the securities of the sector. Seeing the prices fall, more and more investors start booking profits.

#5 - Panic and Downswing

With increased selling and prices plunging, investors are struck with panic and don't know what to do and how to time the market. This is when the bubble bursts and markets crash. Those who cannot exit timely face losses, and these can be huge losses depending upon the stake of investment.

Causes of Price Bubble

One of the main causes is the gap between the performance of the real and the financial economy. Till the time the performance of the real economy meets the expectation of the financial economy, there is no bubble. Still, when the financial economy starts putting in more than necessary confidence in the real economy and its performance starts lagging, the room for the bubble erupts.

The only way to prevent the bubble is to have realistic expectations and conduct due diligence on the market. But unfortunately, blindly following the herd mentality of investing is the biggest cause of the eruption of the bubble.

Conclusion

Price Bubble results from unrealistic expectations and speculation about an asset or a sector's performance or economic performance due to a displacement in the market dynamics. The widening gap between the real sector's performance and the financial sector gives rise to the bubble. If not checked timely, it can cause the markets to crash and investors to lose a lot of money and might even lead to a recession in the economy.