Recognizing a Speculative Bubble

Legal/ tax and helpful subjects

Indicators of price exaggerations

9 minute read

In theory, markets are efficient. They distribute resources to where they are needed most through price mechanisms and free trade. However, the reality is more complex. In theory, man is a market participant with rational behavior. In reality, man is often led by emotions. This can be observed most clearly on financial markets. There, speculative bubbles form repeatedly in a variety of asset classes, leading to price exaggerations.

It’s important for investors to look out for indicators of a speculative bubble. After all, investors want to purchase their traded goods for the lowest price possible and sell them for a higher price. The risk with bubbles is to buy in at the peak, right before the bubble bursts. In this case, price adjustments result in major losses for the investor. We will show you how financial bubbles are created and what indicators point toward price exaggerations.

 

In macroeconomics, speculative bubbles (also financial bubble or economic bubble) are market situations where prices for specific goods (e.g. foods or natural resources) or assets (stocks, real estate, foreign currencies, etc.) are traded above their intrinsic value with high turnover. 

Bubbles have been around on the financial market for a long time. They are the result of speculation. The first well-documented historical speculative bubble was the tulip mania in the Netherlands in the 17th century. People had limited knowledge about the origins of these rare oriental plants and, for a long time, they were only sold in bloom. At the same time, the demand for tulips increased steadily. The prices of the exotic plants thus rose immeasurably.

Merchants even started selling tulip bulbs that they did not own yet. The first short sales were born as a result. The bubble peaked between December 1636 and February 1637. Tulip bulbs were sold up to ten times, increasing their value tenfold in some cases. Finally, on February 7, prices collapsed without any discernible trigger and fell by almost 100 percent. This marked the end of a three-year speculative bubble. However, the bursting of this bubble had no significant impact on the Dutch economy, as only a very small and wealthy social class was involved in the speculation.

The pattern behind a bubble is almost always the same. The price of a commodity increases not because of its fundamental value but because of the hope placed in the commodity. This attracts speculators who are not interested in the commodity but only in short-term price gains. They throw all caution overboard; euphoria dictates market behavior. This multiplies the turnover achieved with the goods and prices rise rapidly until they finally collapse within a short period of time.

 

The many reasons for speculative bubbles are the subject of intense discussion. The most common market models do not explain speculative bubbles, as models assume that market participants have complete information and trade rationally.

Therefore, most explanations conclude that market participants have different levels of information and sometimes act irrationally. The research branch of neurofinance has also empirically proven that many investors in the financial markets are guided by their emotions. The principle commonly known as "greed eats brain" prevails especially in the euphoric phases of a speculative bubble.

One of the most frequent explanations of a financial bubble is the theory of the "greater fool." This theory assumes that there is always an investor who is willing to pay an even higher price because he overestimates his own knowledge and skills. As a result, some investors deliberately pay an exorbitant price, assuming that they will still achieve a higher price return.

Another possible reason for speculative bubbles is the herd instinct. In the social sciences, one speaks of institutionalization when an individual is bound to social norms. In terms of investment behavior, this occurs when investors no longer rely on their own assessment, but on the assessment of other – supposedly more competent – investors.

Inflation can be another reason for bubbles in the financial market. When a country's currency rapidly loses purchasing power, investors flee into other assets, triggering an artificial boom in these stocks. In order to save the declining purchasing power of their money, investors invest more in real estate or shares.

This phenomenon can currently be observed in Venezuela. Although the economy is in a severe recession, the government is on the brink of insolvency, and the country is experiencing the highest inflation in the world, Venezuela's stock market has risen by 4446 percent this year (as of 6 December 2017).

 

Currently, there are signs of bubbles forming in several asset classes. Steen Jakobsen, chief strategist at Saxo Bank, describes the current financial market situation as follows. The markets have reached a phase in which bubbles on the stock market, in cryptocurrencies, government and corporate debts, and in real estate would encounter a new economic reality with negative credit impulses and the end of support from central banks. But how do you recognize a speculative bubble? The following seven warning signals are important indicators of price exaggerations in an asset class. Investors should be extremely cautious when three or more indicators occur.

Warning signal 1: “This time everything is different”

A sure sign of a bubble is when market participants assure each other that "this time everything is completely different" and the previous rules of the financial market no longer apply. They are overly optimistic about the future performance of the asset class and do not see any upward limits in value growth. They often cite "revolutionary technologies" as a reason.

Warning signal 2: The market draws an increasing number of speculators

A sure sign of a bubble is when more speculators enter the market. They have little to no background knowledge of the respective technology or asset class and simply want to make profits with short-term bets on price development.

Asked if we are currently experiencing a bubble in cryptocurrencies, hedge fund manager Mike Novogratz responded: "This will be the biggest bubble in our lifetime, but one can make a lot of money with it until it bursts." The billionaire made a fortune through speculation and returned from retirement specifically to bet on the price development of cryptocurrencies.

Warning signal 3: Rapidly rising prices

One characteristic of a bubble is that speculators move between the different segments of a new asset class at ever shorter intervals in order to maximize their profits from trading. Long-term investments become less attractive. This increases the turnover of the asset class and the prices rise even faster. Bitcoin is a good example to illustrate this phenomenon.

The price of the best-known cryptocurrency rises at ever shorter intervals - a sure sign of a speculative bubble. Bitcoin took 1,789 days to cross the $1,000 mark, and only 1,271 days to reach the $2,000 mark. The digital currency jumped from 2,000 to 3,000 dollars in 23 days. Then the gap became shorter and shorter: Bitcoin went up from $10,000 to $11,000 in just one day, from $13,000 to $14,000 in just 4 hours and from $18,000 to $19,000 in just 3 minutes.

Warning signal 4: Increased media coverage

A good indicator of excessive hype and correspondingly exaggerated prices are frequent media reports on the boom in an asset class. The time of high returns is usually already over by the time everyone's talking about investing. By then, professional investors who speculated on price gains early on are only looking for a way out of the asset class. They anticipate the "greater fool" who is willing to buy the assets at significantly overpriced prices.

Media coverage brings more and more amateur investors to enter the market. This is where the herd instinct starts. Private investors are infected by the euphoria and do not rely on their own assessment. Instead, they follow the alleged experts who make positive forecasts for the future development of the market. Warren Buffet offers some good advice in this regard: “Be fearful when others are greedy. And be greedy when others are fearful.”

Warning signal 5: Low-interest rates facilitate speculation

Speculative bubbles thrive particularly well in times of low-interest rates because interest rates indicate the price of money. In this case, low-interest rates mean “cheap” money. A boom on the stock market leads professional and later on inexperienced investors to start making supposedly safe bets with borrowed money.

This is evident through margin debt, the leverage of the stock market. Investors should exercise caution when stock speculation with borrowed money reaches new highs because leverage increases the risk of rapidly collapsing prices. When share prices fall, the banks, as lenders, ask the speculators to make a margin call. This obligation to make additional contributions can lead to panicked sales and rapidly falling prices.

Warning signal 6: Artificial low volatility

Volatility indicates how susceptible an asset class is to fluctuations. Low volatility is a sign of a stable market. However, caution is advised if volatility is low not due to basic data but due to irrational assumptions by market participants. One example is the European bond market. Interest rates on southern European bonds are at an extremely low level, although the countries there (Italy, Greece, Spain, Portugal) have not solved their structural problems.

The primary reason for investors' optimism is the European Central Bank (ECB). At a press conference, ECB chief Mario Draghi said the ECB would "do everything necessary" to prevent another financial crisis. This includes the purchase of government bonds from states facing a crisis, which prompted investors to buy the securities in the first place. They invest in these bonds even in the event of bad news, assuming that the ECB is ready to act as a buyer in an emergency.

Warning signal 7: “The trend is your friend!”

All market participants firmly believe that the market will still look the same tomorrow. General optimism makes it seem inconceivable that prices will fall. In this phase, financial institutions try to make even more profit from the booming market through financial engineering. They develop derivative financial products with which one can bet on the market development. These multiply the risk of affecting other markets if the bubble bursts.

One example is the real estate crisis in the USA in 2007. The real estate market imploded in 2007 because properties were sold to people with poor credit ratings for years. The banks knew of the imminent loan defaults. Therefore, they packed the distressed loans into a new financial product (securitized mortgages) and sold them worldwide. The buyers firmly assumed that the US real estate market would continue to grow. As a result, a real estate bubble in the USA turned into a global financial crisis.


 


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