Bubbles occur when demand from investors drives asset prices above their intrinsic values, often leading to the creation of a market bubble. When the bubble bursts, prices collapse.
Definition and Examples of a Bubble
A bubble is typically a period in which demand pushes asset prices to unsustainable levels. Bubbles often create the conditions for a market bubble to occur. Investors worry about the existence of a market bubble because if the bubble bursts, prices will drop rapidly.
Former Federal Reserve Chairman Alan Greenspan testified in 2005 that there were “signs of a bubble in some local markets where it seems home prices have risen to unaffordable levels.” At that time, Greenspan questioned the existence of a national real estate bubble. He expressed concern about high-interest loans and adjustable-rate mortgages that pushed families into buying homes they could not afford otherwise.
After peaking in July 2006, real estate values began to decline. The U.S. National Home Price Index S&P/Case-Shiller continued to record consecutive declines for 32 months. Many risky loans made during the market bubble period defaulted. These loans were often bundled into mortgage-backed securities, resulting in losses reaching hundreds of billions of dollars. The real estate bubble led to the massive financial crisis that followed in the fall of 2008.
Another example of a bubble market is the period before the dot-com bubble burst in 2000. In the mid-1990s, investors flooded money into tech companies, including failed startups like Pets.com. The tech-focused Nasdaq hit a record high of 5,048.62 on March 10, 2000, then began to decline. The index lost more than 75% of its value over the next two and a half years and did not surpass the record level of March 2000 until April 23, 2015.
How the Market Bubble Works
A bubble occurs when asset values are inflated. Often, the market creates a bubble that eventually bursts. However, rising prices alone do not indicate the existence of a market bubble or asset bubble.
A hallmark of a bubble is that asset prices are rising at a rate not justified by fundamentals. As a result, these price increases cannot be sustained in the long term. Price increases are often driven by what Greenspan described as “irrational exuberance.”
Indicators of a market bubble include easy access to money and investor confidence that a specific trend – such as rising tech stocks in the 1990s or home prices in the early 2000s – is the new normal. If prices decline and then money contracts, prices are likely to fall further.
Note: The cyclically adjusted price-to-earnings ratio (CAPE) is the stock price divided by its earnings adjusted over ten years. Some investors apply this formula to stock indices, such as the S&P 500, in an attempt to predict stock market bubbles. Although it has provided accurate information in the past, some researchers have recently criticized it for being “excessively pessimistic.”
What It Means for Individual Investors
While a decline in asset prices may seem scary for investors, if you have a long-term investment outlook, you do not need to worry about short-term declines.
Overall, there are benefits to investing for the long term. For example, research shows that investing for 20 years in the S&P 500 at any time between 1919 and 2020 consistently produced positive returns.
During
Market fluctuations can make it tempting to sell your investments to limit your losses. However, retail investors are advised to manage their portfolios and endure market volatility.
Researchers have found that a significant number of investors in the United States sell risky assets during sharp declines, a phenomenon known as panic selling. While this provides them with protection from short-term losses, it also means they miss out on long-term opportunities when markets rebound.
However, if you’re concerned about bubble signs, there are steps you can take as an individual investor to protect your money.
A diversified portfolio can shield you from the burst of market bubbles. Maintaining a mix of stocks and bonds is essential. You can also diversify within your stock portfolio by investing in different sectors of the stock market, investing in stocks with varied market capitalizations, and a blend of growth and value stocks.
Some investors seek to profit from market bubbles. They may plan to sell assets before they start to decline, or they may try to make money from the decline by short-selling stocks.
Note: Short selling is risky because there’s theoretically no limit to how much loss you can incur.
Additionally, timing the market to know when is the best time to sell before a market decline is challenging. Therefore, market timing and short selling are both risky moves.
You may hear market commentary about bubbles and market froth, but they are typically unpredictable. No one can know for certain when a bubble might turn into an asset bubble or when that bubble will burst.
Key Takeaways
A market bubble occurs when the price of an asset is inflated. Bubbles often lead to bursts.
Not just the increase in prices signifies a bubble. However, rising prices at a rate not justified by fundamentals is a sign of market froth.
The periods preceding the dot-com bubble burst in 2000 and the financial crisis collapse in 2008 are examples of bubbles that eventually turned into asset bubbles.
Source: https://www.thebalancemoney.com/what-is-froth-5206430
Leave a Reply