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What are Asset Bubbles and how to avoid being in one.

May-18-2022


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You may have heard the term 'asset bubble' often, in the media, from acquaintances and more and we covered some of the major ones that have occurred in a previous blog post.

 

So, what is the exact meaning of the term and why learning about it is important as an investor? 

 

An asset bubble simply refers to a situation wherein the asset prices are much higher when compared to the underlying fundamentals. These are also called speculative bubbles, financial bubbles, or speculative mania.  Not only have asset bubbles wiped out the wealth of investors, they have often also led to the collapse of entire economies.  Also, bubbles keep emerging.

 

And, while we hear warnings of a bubble emerging every now and then, it is indeed difficult to identify one in time to avoid losses.  Many times, the investment opportunities that seem to be the hottest are the ones headed towards a bubble.

 

In the initial stages of an asset bubble, investors fail to realize the reasons for the rise in prices, deeming it justified. This is why bubbles are often identified when the prices have already crashed. 

 

Acclaimed economist Hyman P Minsly has identified 5 stages of an asset bubble: 

 

1. Displacement: This occurs when investors get attracted to a new paradigm such as low-interest rates or innovative technologies. For eg, the decline in US Federal fund rates from 6.5% in July 2000 to 1.2% in June 2003. During this three-year period, the interest rates on mortgages/housing loans fell by 2.5%, leading to the housing bubble.

 

2. Boom: In this scenario, the price of assets first increases slowly, following displacement, only to gain momentum with more and more participants entering the market. Here, the asset in question attracts extreme media coverage. Fear of missing out spurs speculative behaviour in the investors, further forcing them to make the wrong decisions. 

 

3. Euphoria: In this phase, the asset prices skyrocket and valuations reach extreme levels. It's got more to do with the greater fool theory, i.e. the idea that irrespective of the price rise, there will be people willing to buy the asset sometimes only out of FOMO.

 

4. Profit-taking: This phase is characterized by smart money i.e. savvier investors- heeding to warning signs of a bubble burst, smart investors start selling their assets in lieu of profits. But it's difficult to predict the accurate time for the bubble burst at this stage. 

 

5. Panic: It merely takes a spark to initiate the asset bubble burst. In this stage, asset prices reverse course and fall as quickly as they had increased. Investors, facing uncertainty, look to liquidate their holdings at any price. With supply overwhelming demand, asset prices slide sharply. For example, when Lehman Brothers declared bankruptcy, the S&P 500 plunged by 17% in October 2008. 

 

But what causes this? Let us find out. 

Causes of Asset Bubbles

There are several underlying causes for asset bubbles. These causes should be well understood by an investor before they take a plunge into the market. 

 

Below are some major causes of Asset bubbles: 

  1. Monetary Policy

  2. Demand Inflation

  3. Irrational Exuberance

  4. Global Imbalances

  5. Asset Shortage

  6. Following the Majority

  7. Monetary Policy Impact

  8. Short-sightedness and Adaptive Expectation. 

 

Let us now evaluate and understand each of these causes in detail. 

Monetary Policy and Low-Interest Rates

In a market when interest rates are low, it becomes very easy and cheap to borrow money. This further boosts investment spending. For example, the U.S. Federal Reserves' decision to keep the interest rates low led to the credit bubble in the U.S. However, low-interest rates also mean that investors will not be able to receive good returns. This is why they tend to move their money into high yield, high-risk asset classes only to further spike asset prices, in return leading to an asset bubble. Also, monetary policy has a direct impact too. Similarly, excess liquidity also has its effects as people look for avenues to invest extra money at their disposal.  

 

Those familiar with the VC/startup space may well remember how funding activity gets frenzied when interest rates are low as more money moves into VC funds seeking quick deployment. For instance, the IPO market is on a tear due to the frenzy in the interest towards startups. Moreover, the RBI is helping in fanning a world-beating share market rally coupled with low interest rates, and huge injection of liquidity. 

Demand-pull Inflation

In simpler terms, demand-pull Inflation is a type of inflation that is caused due to an increase in demand for goods and services. Similarly, when the investors' demand for a particular asset exceeds the supply, the seller is compelled to increase the price of the asset. This sudden rise in price creates a situation of an asset bubble.  A familiar example of this is that of commodities such as metals, oil, or even the more novel carbon credits.

 

The housing market in India was in full bloom till early 2013 due to high demand of flats as home loans were cheap.Builders were not able to fill the soaring demand leading to a spike in resale prices and new flats. The bubble burst with a depreciating rupee, high inflation as well as the increase in cost of money. Hence, investors were not ready to pump in money. In September 2013, real estate prices in investor-driven markets such as Noida, Ludhiana and Navi Mumbai recorded a price crash of 20%. These regions once had ample of housing projects under plan and construction. However, the prices of these apartments remained flat as they remained unsold or investors sold it quickly in lieu of slim profits. 

Irrational Exuberance

Many times, investors end up making the wrong decision. This decision may or may not be backed by data or trends. For instance, investors can merely buy assets because of extreme psychological pressures or FOMO. During such situations, they tend to ignore the fundamental worth of the asset, instead of believing that the price will continue to rise. Recent instances from the crypto markets contain many examples of irrational exuberance.

Global Imbalances

It's been seen that global imbalances have a direct impact on the asset market. This can be understood from a hypothesis that suggests that the U.S. financial bubble of the 2000s was a result of massive inflow of foreign currency in the economy. The U.S. continued with a trade deficit which attracted high money inflows. This led to higher demand for U.S. securities in the market. Hence, the interest rates continued to be low.

Asset Shortage

Being a self-explanatory term, asset shortage is one of the main causes for an asset bubble. This situation predominantly arises when investors begin to believe that there is a shortfall in the given asset in the market. Such shortages lead to asset bubbles because the difference between the demand and supply results in the appreciation of the price of the assets in the market. The recent increase in semiconductor prices after cutting back of production during COVID is an example.

Following the Majority

It is a human tendency to believe and agree to what the majority is saying. That's what happens in the market scenario as well. Investors go on to assume that the majority will never be wrong. For instance, if banks and financial institutions are investing in an asset, they too end up doing the same, which could be detrimental. 

 

For instance, in 1992, the Indian stock market skyrocketed to new levels. Harshad Mehta manipulated the stocks to such levels that an ACC stock price went from Rs. 200 to Rs. 9000 in just three months. People started believing that the Indian stock market was a 'goose laying golden eggs' and started investing for better returns. However, only a few knew that the bubble was soon going to burst, which did; leading to a 50% stock crash in four months. 

Short-sightedness and Adaptive Expectation

It is generally seen that investors end up making decisions keeping in mind the short-term objectives rather than long ones. Besides, they also end up judging and forecasting the market based on past performance, while ignoring other key aspects. 

How to avoid being in an asset bubble?

We've already seen that low-interest rates, demand-pull Inflation, and supply shortage are some of the key factors to watch out for. Similarly, it's also important to look for irrational exuberance. As an investor, if you feel that the price of an asset is not justified, avoid buying it, although it may seem to be a profitable bet. 

 

Instead, opt for a well-diversified portfolio when investing. Diversification, in simpler terms, refers to investing in a balanced mix of stocks, fixed-income, and traditional and alternate assets. You should also revisit your asset allocation at regular intervals to ensure that the investment is still balanced. If there's an asset bubble in gold or housing, it will tend to drive up the percentage you have in that asset. That's when you should sell your assets to be on the safer side. 

 

Don’t get carried away or invest out of the fear of missing out.  Choose investments where you can understand how value is created and returns are delivered.

 

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