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Identifying 'Asset Bubbles'

Aug 30, 2010

Wikipedia defines an asset bubble as "trade in products or assets in high volumes at prices that are considerably at variance with the intrinsic value". Let's try and break this definition down to make things clearer. A bubble is said to exist if the following conditions are met:

In short it is a 'temporary' market condition that is created through excessive buying wherein an unfounded run up in prices occurs.

What are the characteristics of a bubble?

Having identified what a bubble is. Let us now try and build a model of characteristics that are typical to an asset bubble. Late monetary theorist, Hyman Minsky helped us out with this one.

  • Displacement - There is usually a major shock to the macroeconomic system that leads to the beginning of a bubble build up. This shock maybe good or bad. Such a shock brings about a displacement or a radical change. This change could lead to opportunities for profit in some 'new' or till now ignored avenues. And may also lead to closing of some popular investment avenues.

  • Expansion of credit: There is a growth in the level of debt in the system that feeds the boom. The total supply of money in the system expands and most of it is channeled towards buying the asset.

  • Euphoria: As demand for the asset increases, the prices start to rise. The urge to speculate starts to kick in that send the prices spiraling upwards. The net result is that investors start living in a paradise that prices of the asset would keep going up. There kicks in a state of 'euphoria' surrounding it.

  • Speculative boom: As investors start to rush in, they start to rationalize their investments. They do this by overestimating their profits. They start to justify the returns using big words and jargons. The prices of the asset literally boom at this point of time. Such a stage may last for some time. It could even extend to some years.
Hence a 'bubble' comes to exist in the market. Some examples of bubbles in history would be:

The Great Depression (1929): The Americans were all gung ho about the stock markets. The stock market almost offered a guarantee to make everyone rich. People were investing in all kinds of stocks. The fundamentals of the underlying companies did not hold any importance. Investors kept pouring in more and more money into them. By the end of the depression in 1932, the markets had crashed almost 90%.

Source: Yahoo Finance

'Dotcom' mania: Internet was the buzzword at this time. Anything even remotely related to internet would definitely be a 'hit'. The stock markets went after companies that just defied common logic and created bogus valuations that just did not justify fundamental reality. The euphoria could not be justified through conventional accounting. The NASDAQ index finally crashed by 78% by mid 2002 leading to a 'burst' in the bubble. The internet stocks never again traded at the high valuations seen during the mania.

Source: Yahoo Finance

The aim of this article was to understand what asset bubbles are and what are the typical characteristics that can be associated with them. Over the next few articles we will examine some popular investment destinations that are being talked about in recent times. And we will try to see if these have the characteristics of being a 'bubble' or not.

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