Even if you don’t pay much attention to markets or investments, you’ve probably heard the term “bubble market.”
The global housing bubble of the early 2000s led to the subprime mortgage crisis. The dotcom bubble of the late 1990s led to the dotcom crash. The South Sea Bubble of 1720 cost Sir Isaac Newton millions of pounds in today’s money.
But how exactly can we define a market bubble?
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Given that it’s probably one of the most famous terms in investing, it’s somewhat ironic that the correct answer to that question is “we can’t.”
There is no recognized specific definition of a market bubble.
This is partly because the theory of financial markets is based on models that assume that markets are rational. Most people know that this is not the case in practice, but it still makes it difficult to fit an emotional phenomenon like a bubble into existing theories.
However, it is also because it is difficult to hold a bubble.
Does a market bubble just mean a high valuation? Well, no, it’s more than that.
Tech stocks could look expensive in recent years. But they have been positively tame compared to their valuations in the dotcom era. And US stocks have looked expensive by most valuation measures for the past decade. However, there is no sense of the wild optimism and “fear of missing out” that characterizes the most infamous bubbles.
If anything, it is this aspect of sentiment that separates a genuine bubble market from one that is simply expensive. Every bubble starts with a good fundamental story, often related to technological change or a genuine shortage of supply of the bubble asset.
As the asset rises in price and the story becomes more widely known, there is a sense of almost manic desperation to get on board. The price spikes, then spikes some more, as more and more investors are sucked in.
Investors and company experts who got involved early on see that the high prices are no longer justified by what is happening on the ground. They start selling even as more naive buyers keep coming in to add fuel to the fire.
But eventually, there are no new buyers left to buy and the bubble bursts. Those who are late lose the lot.
This brings us to the final aspect that makes bubble detection so tricky: You can only know for sure that it was a bubble after it has burst.
Our most recent example of a bubble may be in the cryptocurrency space. In November 2021, Bitcoin reached an all-time high price of $68,000, leading a cryptocurrency rally fueled perhaps by low interest rates and fear of missing out. Since that watermark, all the major cryptocurrencies have seen dramatic price drops as financial conditions have tightened.
Bitcoin’s price today is below $17,000, having given up all gains since December 2020. Many other cryptocurrencies have fared even worse. This dramatic drop in asset prices has created a financial contagion of widespread losses and sell-offs among cryptocurrency owners, along with failures among cryptocurrency companies large and small. It certainly feels like a bubble has burst.
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