What Is a Financial Bubble and How to Recognize One?

Photo by Mathieu Turle on Unsplash

A bubble is an economic phenomenon during which the price of an asset rises quickly, only to subsequently deflate.

When it does, the bubble is referred to as having “burst”.

Bubbles are often called such after their explosion, which makes them difficult to repair for those that don’t know about the signs.

Bubbles can happen in an economy (US, Japan) or for a specific asset (from tulips to Bitcoin).

Let’s see first what they look like and how they unfold.

Examples of Economic Bubbles

Tulipmania: 1634–1637

At the end of the 16th century, the Dutch were introduced to the tulip, a flower from the Ottoman Empire.

This coincided with the rapid development of the Dutch economy during the era known as the Dutch Golden Age.

As the population got richer due to trade, higher social classes took an interest in these colorful plants.

Botanists started mixing seeds together to get brighter colors. Prices started their increase in 1634.

Different investors saw that and started negotiating seeds at a high price to hopefully sell them higher later on.

The value of the bulbs increased faster and faster.

At the top of the bubble, one bulb of tulip was sold for 10 times the annual salary of an artisan.

The price peaked in February 1637. At that point, no one had enough money to buy the bulbs, so the price slowly decreased, then crashed.

Several people lost their livelihoods, and many debts could not be repaid.

The tulipmania was considered to be the first speculative bubble ever.

The Japanese Economy: 1986–1992

At the beginning of the 1980s, the Japanese economy was booming due to strong demand for its high-tech products both locally, and internationally.

People earned more money and invested it in the stock market which was fastly appreciating.

In 1985, the Plaza Accords signed between Japan, France, the UK, the US, and Germany devalued the US dollars.

As a result, the Japanese yen increased in value which threatened to slow down the exportations.

So the Bank of Japan devalued the yen by cutting interest rates and making it easy for everyone to borrow.

The inflow of fresh money into an economy that was already booming accelerated the rate at which assets were increasing.

The bubble burst in 1992 when both the stock market and real estate market decreased. In the most extreme cases, some properties were worth 1% of the price from their peak.

The economy subsequently embarked on a “lost decade” during which there was no economic growth. The prices of real estate in Japan only began to rise again in 2007.

The Internet Bubble: 1995–2000

The bubble is said to have started in 1995 because computers were getting cheaper, Windows and other Internet browsers had been released, and more and more families gained access to the Internet.

Low-interest rates in 1997, easy VC funding, greedy banks that profited from IPOs, and confidence in the technology saw many entrepreneurs borrowing monstrous amounts of money to launch and list companies that weren’t profitable on the stock market.

Between 1995 and 2000, the Nasdaq grew by 400%. It peaked in February 2000 and lost 77% of its value by September 2002.

The US Real Estate Bubble: 1999–2008

In 1999, mortgage lenders started giving mortgages to people in the US that didn’t have the means to repay them. These mortgages were called subprimes.

Since more people bought houses, the real estate market increased in value.

In the beginning, subprime borrowers didn’t have to repay much of their loans. But as time went by, the monthly payments increased.

When the US economy started to slow down in 2006, borrowers ended up stuck between low-paid jobs (or the difficulty to find work at all) and rising monthly payments.

Meanwhile, since mortgage lenders knew these loans were likely to default, they sold them to US banks which sold them to other banks around the world.

Three things happened simultaneously in 2007.

  1. The real estate market peaked in value
  2. There wasn’t anyone left to lend money to
  3. Those that borrowed were defaulting en masse

Banks seized the houses of defaulting borrowers and put them on the market.

So the real estate market simultaneously had a huge drop in demand (no one was buying), and a huge increase in supply (everyone was defaulting).

The price of houses collapsed, banks could not refund their debts, and many went bankrupt.

This bubble was particular. People that were buying houses weren’t doing it out of greed, and they didn’t know they were participating in a bubble.

The greed came from mortgage lenders that were working on commissions, bank executives that were working on commissions, and mortgage insurers that were working…on commissions.

Furthermore, the debt that fueled the bubble was sold to other countries.

Had US banks kept the loans and not sold them to other banks, the US economy would have been devastated, but the rest of the world would have remained reasonably unharmed.

The Bitcoin Bubble: 2020-?

In September 2020, the price of Bitcoin started an ascent from roughly $10 000 to more than $60 000 per coin in July 2021. By July 2022, the price had been divided by 3.

There are several causes for the rise of Bitcoin.

First, the highly-publicized money printing operated by central banks around the world spurred inflation fears, and people invested in crypto-currencies.

Second, the money printed by central banks around the world had to go somewhere, and a lot of it went into crypto-currencies.

Third, the company behind the so-called stablecoin Tether artificially printed Tether to inflate the price of Bitcoin.

Fourth, retail investors got into Bitcoin, encouraged by people such as Michael Saylor and Elon Musk, hoping to make a quick buck.

The price of Bitcoin is still crashing as these lines are written.

Why do Bubbles Happen?

There are two types of bubbles. Some are fueled by debt, and some aren’t.

The US real estate bubble that led to the subprime crisis, for example, was fueled by debt contracted from banks.

The Internet bubble was mostly fueled by VC money.

Economists don’t know exactly why nor how bubbles happen, but all of them happen due to at least one of these two causes:

  1. Greed: When investors see an asset that can make them quick cash easily, they rush. This explains the rush to cryptocurrencies or tulips (buy and hold) and the inevitable fall.
  2. Money printing and low-interest rates: when money is printed, it needs to go somewhere. As we have seen in 2021, or during the Japanese bubble, it often goes to real estate and equities.

How to Recognize a Bubble

Look at the following graphs.

Bitcoin price: last five years.

Source: Google

Japanese Nikkei: 1970–2010

Source: Macrotrends

Nasdaq: 1971–2022

Source: Macrotrends

Bubbles always start off with a quick price acceleration, only to subsequently fall.

Another sign is news headlines. Words such as “mania”, “crazy”, “keeps on gaining” are signs that a bubble is forming.

“Shortages”, “can’t afford”, “top” are words indicating that a bubble is about to pop.

How to Profit Off a Bubble

There are two ways to do so.

  1. Buy when the asset price is still low. In this case, that’d mean buying Bitcoin at $10 000.
  2. Sell/short when the prices are so exuberant that they can only fall down.

In effect, that means going the opposite way.

When no one is buying, buy.

When everyone is buying, sell.

Waiting for a bubble to pop and bottom is also another way to profit from it.

Conclusion

You are now equipped to recognize financial bubbles when you see them and avoid falling into their trap.

Assets that are illiquid (difficult to buy and sell) are less likely to be victims of bubbles because liquidity is extremely important.

LandEx operates due diligence before listing its plots to ensure that they’re correctly priced and won’t decrease in value in the future.

Visit landex.ai, and begin your land investment journey today.

The content of LandEx’s blog is for informational purposes only, you should not construe any such information or other material as investment, financial, or other advice. Nothing contained on the LandEx Medium blog constitutes a solicitation, recommendation, endorsement, or offer by LandEx or any third-party service provider to buy or sell any financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction.

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LandEx is the first European investment platform enabling any EU retail investors to invest in farmland. Find out more at https://landex.ai