What is a Bubble?

An economic bubble is like building a house on an unstable foundation…

When it comes to building a home, a solid foundation is critical to make the home last. A poor foundation cannot support a home over the long term. Similarly, a bubble is a price increase that’s built on a weak foundation. Eventually, the bubble bursts and the price falls.

A bubble (aka economic bubble or asset bubble) is an increase in the market value of a particular asset beyond its real value. Bubbles happen when buyers are willing to pay exceptionally high prices for an asset.

A speculative bubble is another name used to describe economic bubbles. It’s a situation where the trading price of an asset is significantly greater than its actual value. Bubbles tend to be speculative because people buy with the expectation that the asset’s price is going to continue increasing.

A prime example of a speculative bubble was the Beanie Baby bubble of the 1990s. Some people paid thousands of dollars for the popular stuffed dolls that typically sold for $5. They envisioned that down the road, they’d be able to sell the toys for a profit to help them pay for retirement or college for their kids.

An economic bubble typically starts with the rise in popularity of a particular asset. As popularity grows, demand becomes greater than the supply, and prices go up. Some people are willing to spend more and more money on the asset because they believe the price will continue going up.

In most cases, however, the bubble eventually bursts. The demand for the asset goes down, as does the market price. Many who own the asset rush to sell before prices drop too far. As a result, the supply becomes much greater than the demand and prices drop drastically.

Some of the most famous economic bubbles have happened in just the past few decades, but bubbles have been occurring for much longer. Here are a few of the most significant examples throughout history:

1. The tulip bubble: Economic bubbles aren’t just a modern phenomenon. One of the most famous bubbles dates back to Holland hundreds of years ago. In the 16th century, tulips made their way from Turkey to Holland for the first time. Throughout the early 1600s, the flower became insanely popular. Prices went up as a result of the increased demand. People treated tulips like an investment, even putting their homes up as collateral to buy more flowers (a physical item someone agrees to give to a lender if they fail to pay back a debt). This bubble is now known as Tulipmania. By 1637, the bubble burst. The price of tulips dropped to almost zero, leaving those who spent so much of their money on the flowers financially devastated. People continued to buy tulips; they just weren’t willing to pay astronomical prices for them anymore.
2. The dot com bubble: Today the internet is an integral part of everyday life. But in the 1990s, it was still new and exciting. During the late 90s, as more and more people started using the internet, the United States went through a dot com bubble (aka tech bubble). The stock market reached record highs as people invested in new internet companies (such as Pets.com). On March 10, 2000, the bubble burst. The stock prices of dot coms plummeted, and those who had invested heavily in them lost a lot of money. In less than one month, the market lost nearly $1T in stock value. Just a few years later, the losses reached $5T. Though the internet hasn’t become less popular since, the stocks were overvalued because of their perceived resale value.
3. The housing bubble: In the early 2000s, housing prices rose rapidly, increasing by 50-100% in some cases over a short period of time. The bubble burst in 2007, bringing down the US economy and exposing lending practices that contributed to the crisis. Banks had been giving more subprime mortgages (mortgages given to borrowers with low credit scores), then packaging those mortgages as high-quality investments and selling them. When the bubble burst, and people couldn’t sell their homes, they stopped making their payments. When they stopped paying, investors who had bought the mortgages lost their money. These events led to the financial crisis from 2007-2009.

Bubbles are a result of the willingness of buyers and investors to pay more for an asset than it’s really worth. In most cases, people are willing to pay higher prices because they believe that prices will continue to rise. They believe they’ll have the option to sell the asset later at a higher price.

Economist Hyman P. Minsky, a leading expert on economic stability identified the five steps of a bubble in his book, Stabilizing an Unstable Economy.

1. Displacement: This phase is the start of a bubble. It’s the time at which investors start to get excited about a particular asset. Displacement often comes as a result of a market shift. For example, in the early 2000s, interest rates dropped, which led to more people buying houses.
2. Boom: Once an asset becomes popular during the displacement stage, prices begin going up during the boom phase. Asset sales gain momentum and people want a piece of the expected profits.
3. Euphoria: The euphoria phase of a bubble is when asset prices reach unusually high prices. It was at this phase during the Beanie Baby frenzy that people were willing to spend thousands of dollars for a single toy.
4. Profit-taking: During the profit-taking phase of a bubble, some investors start realizing that the bubble isn’t going to last forever. People begin selling off their assets while prices are at their peak. It’s at this point that the bubble begins to burst.
5. Panic: The panic stage takes place after the bubble bursts. People see the asset’s price dropping, and they’re eager to sell theirs before it’s too late to recover their investment. The number of people trying to sell outgrows the number of people trying to buy, prices drop even more. After the housing bubble burst, in October 2008, the S&P 500, which measures the performance of the 500 largest publicly-traded companies, saw one of its worst months in history, as large financial institutions declared or neared bankruptcy.

There’s no crystal ball that can tell investors when exactly a bubble will burst. But some signs may indicate that a bubble has burst, including:

• There’s more of an asset on the market, which may mean that more and more people are trying to sell.
• An asset’s price declines, which may reveal that the asset isn’t worth what it was at the peak of the bubble.
• There’s a lack of liquidity, which means some investors may struggle to find buyers.

Because every bubble looks a bit different, it can be hard to recognize the exact signs of a bubble burst. But when prices plummet after a bubble bursts, they generally don’t bounce back for a while or they may never recover. It’s also important to note that high supply or declining prices don’t necessarily indicate the burst of a bubble, but that tends to be a part of the pattern.

No one can know for sure when the next economic bubble will happen or when it will pop. Some economists and analysts have a few guesses based on their research or expertise. Here are a few theories:

• The housing market. Though real estate just went through a significant bubble burst in 2007, some believe another could be on its way. After the Great Recession, the Federal Reserve Bank lowered interest rates to make mortgages more accessible. As a result, more people bought homes and housing prices once again began to rise. In addition to homeowners, many entrepreneurs bought homes to rent out. But when travel slowed down in 2020 as a result of the COVID-19 pandemic, many owners lost their rental income. At the same time, many Americans lost their jobs, making it more difficult to make home payments. It’s worth noting that even before the COVID-19 outbreak, experts were predicting the housing market would go through serious changes, including a decline in housing values.
• US government debt. US government bonds have become an increasingly popular investment option. These bonds are often considered to be low-risk investments because they are backed by the government and carry lower risk of the issuer failing to pay back its debt, compared to other bonds. As US government bonds have become more popular, their prices have risen. Some believe these prices are artificially high and may eventually fall. As a result, some investors may not be able to recover their initial investment if they try to resell the bonds in a secondary market.
• Tech stocks. 2020 was a tumultuous year for the stock market, with many stock prices dropping due to the COVID-19 pandemic. But tech company stocks have bounced back quickly, nearing all-time highs in June 2020 and rising from there, even as other sectors recover slowly or not at all. Some analysts believe the discrepancy between the performance of tech stocks and the rest of the market could be a sign of a bubble.