It can seem obvious in hindsight that the housing market was overvalued in the mid-2000s, or that internet companies’ stocks were inflated in the 1990s, but at the time investors were simply excited by the asset classes.

 Economist John Maynard Keynes once noted that “spontaneous optimism” is a larger driver than mathematical analysis for the economy. The market creates asset bubbles because of what modern economists call irrational exuberance.

What is an Asset Bubble? 

Generally, bubbles are only recognized after the fact, once the bubble bursts. Even so, some economists have identified five stages of a bubble that could prevent the unwary from getting caught up in one. 

The term “bubble” in an economic context refers to a situation where the price for an asset exceeds its fundamental value by a large margin. The asset in question can be an individual stock, a certain financial asset, or even a sector, market, or entire asset class. 

The price surge in that asset is fueled by speculative demand, rather than intrinsic worth, so the bubble will inevitably pop. Once a bubble pops, massive sell-offs cause prices to decline, typically very dramatically.

In most cases, a speculative bubble is followed by a large crash. 

Types of Asset Bubbles 

Any asset can become a bubble, and we have seen quite a few from the speculative frenzy caused by a variety of different assets — cryptocurrencies, meme stocks, housing, and even tulip bulbs. In general, asset bubbles fall into one of the four basic categories. 

Stock Market Bubbles 

Asset bubbles that involve equities are stock market bubbles, stock prices rise rapidly in price, often out of proportion to their companies’ fundamental value. These bubbles can include the overall stock market, ETFs, or equities in a particular industry or sector such as internet-based businesses which fueled the dotcom bubble of the late 1990s. 

Asset Market Bubbles 

These involve other industries or sectors of the economy, outside of the equities market. The housing market is a classic example. Run-ups in currencies, either traditional ones like the US dollar or euro or cryptocurrencies like Bitcoin, could also fall into this bubble category.

Credit Bubbles 

Credit bubbles involve a sudden surge in consumer or business loans, debt instruments, and other forms of credit. Specific examples of assets include corporate bonds or government bonds, student loans, or mortgages.

Commodity Bubbles 

Bubbles that involve an increase in the price of traded commodities, hard materials and resources, such as gold, oil, industrial metals, or agricultural crops, are commodity bubbles. 

5 Stages of an Asset Bubble 

Economist Hyman P. Minsky was one of the first to explain the development of financial instability and the relationship it has with the economy. In his book Stabilizing an Unstable Economy (1986), he identified five stages in a typical credit cycle that was then extended to other financial bubbles. 

Stage 1: Displacement 

A displacement occurs when investors frenzy over a shift in the economy, such as an innovative new technology or historically low interest rates. 

Stage 2: Boom 

Prices rise slowly at first following a displacement but then gain momentum as more and more participants enter the market, setting the stage for the boom phase.

During this phase, the asset in question attracts widespread media attention. Fear of missing out on what could be a once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of investors and traders into the fold. 

Stage 3: Euphoria 

During the euphoria phase, investors throw caution to the wind, and asset prices skyrocket. Valuations for the asset reach extreme levels, often new kinds of measures and performance indicators are introduced in an attempt to justify the higher values. In this phase, investors often think there is no ceiling to how expensive the asset can get, and always believe there will be someone else willing to buy the asset for a larger price.  

Stage 4: Profit-Taking 

In this phase, institutional investors who have access to more market information begin selling positions and taking profits. But estimating the exact time when a bubble is due to collapse can be a difficult task because, as economist John Maynard Keynes put it, “the markets can stay irrational longer than you can stay solvent.” 

Stage 5: Panic 

It only takes a relatively minor event to prick a bubble, but once it’s pricked, the bubble cannot inflate again. In the panic stage, asset prices reverse course and descend as rapidly as they had ascended.

Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate at any price. As supply overwhelms demand, asset prices slide sharply. 

One of the most vivid examples of global panic in financial markets occurred in October 2008, weeks after Lehman Brothers declared bankruptcy and Fannie Mae, Freddie Mac, and AIG almost collapsed. The S&P 500 plunged almost 17% that month, its ninth-worst monthly performance. 

Historic Asset Bubbles 

The US has experienced a handful of major market bubbles in the recent past, but asset bubbles have occurred globally for hundreds of years. Classic examples include Japan’s real estate and stock bubble in the 1980s, the 18th century’s South Sea bubble, and even the emerging concern of a student loan bubble or a cryptocurrency bubble.

Major asset bubbles create financial losses that tend to scar economies for decades.

The Dutch Tulip Bubble

Tulip mania gripped Holland in the 1630s in one of the earliest recorded asset bubbles. During the Dutch Tulip Bubble, tulip prices rose twentyfold between November 1636 and February 1637 before falling 99% by May 1637.

The Dot-Com Bubble

The dot-com bubble of the 1990s is one of the largest asset bubbles in economic history. At the time, the increasing popularity of the internet triggered a wave of speculation in internet businesses. As a result, hundreds of internet companies reached multi-billion dollar valuations as soon as they went public.

The NASDAQ Composite Index, the tech-heavy index, soared from around 750 at the beginning of 1990 to over 5,000 in March 2000. At the time, the combined value of all technology stocks on the NASDAQ was higher than the GDP of most countries.

Shortly after, the index plunged 78% by October 2002 and triggered a US recession. The next time the NASDAQ reached a new high was 15 years later, in 2015.

The U.S. Housing Bubble

The 2005 real estate bubble in the US was stoked by credit default swaps that were used to insure financial derivatives such as mortgage-backed securities and collateralized debt obligations (CDOs).

Some economists cite the dot-com bubble as why so many investors piled into real estate, because they saw it as a safer asset class. At the time, hedge fund managers created a huge demand for these “less risky” derivatives, which in turn boosted demand for the mortgages that backed them. To meet the new demand, banks and mortgage brokers offered home loans to nearly anyone, including subprime borrowers.

U.S. housing prices nearly doubled from 1996 to 2006, and two-thirds of the increase happened from 2002 to 2006, according to the U.S. Bureau of Labor Statistics. When homebuilders finally caught up with the demand increase, housing prices started to fall in 2006.

The average US house lost one-third of its value by 2009. The US housing boom and bust, and the effects it had on mortgage-backed securities, created the largest global economic contraction since the Great Depression. This period of the late 2000s became known as the Great Recession.

What Causes an Asset Bubble? 

Economic bubbles can begin in any number of ways, and often for understandable reasons. Common conditions that contribute to irrational exuberance and subsequent asset inflation include:

• Low interest rates: The Federal Reserve lowers interest rates to encourage borrowing for spending, expansion, and investment. However, investors cannot receive a strong return on their investments at these rates, so they move money into higher-yield, higher-risk asset classes, spiking asset prices. Low interest rates and other favorable conditions in a nation can also encourage an influx of foreign investment and purchases, which can inflate prices.

• Demand-Pull Inflation: This occurs when consumers’ demand for an asset exceeds the available supply, often with new technology or innovation. The sellers of the asset then raise the prices.
• Asset Shortage: If investors believe there is not enough of a given asset to go around, the cost of the asset will climb. These shortages make asset bubbles more likely because the imbalance between supply and demand leads prices to rise beyond the asset’s intrinsic value.

When is a Price Increase Not Considered An Asset Bubble?

When the price of an asset increases in correspondence with an asset’s fundamental value, that price increase is not an asset bubble. However, it can be difficult to determine what the intrinsic value of an asset is and when prices deviate from that value.

What Happens When an Asset Bubble Bursts?

When an asset bubble eventually bursts, the prices for that asset depreciate. The magnitude of the losses depends on how inflated the bubble got before it burst and how many investors were involved.

Sometimes the effect can be small, causing losses to only a few people, or only short-term losses. At other times, it can trigger a market crash, global financial crisis or even depression. 

Much of the outcome depends on the bubble’s size, whether it involves a relatively small or specialized asset class or a significant sector. It also depends on how many people and how much investment money is involved. 

What Are Asset Bubble Warning Signs? 

While asset bubbles can typically only be identified once they have burst, there are some indicators that an asset is overheating.

A Compelling Story

One sign is when an investment story captures the market’s attention. The dot-com bubble was stoked by the market sentiment that “the internet changes everything,” while the housing bubble of the 2000s inflated because “real estate never declines in price.” When there are stories surrounding assets or stocks that promise to transform the world, this is generally an indication of inflated prices.

These stories often make their way to the mainstream in a way other investment news does not. This was seen a lot with the rise of meme stocks in 2021 or the eruption of cryptocurrencies and NFT investors. Meme stocks such as AMC and GME are examples of relatively short-lived and small asset bubbles that grew due to a compelling story online.

Prices Rising Regardless of News

Because asset bubbles are fueled by investor excitement and not fundamentals, every bit of information that comes out about the asset will verify the story in investors’ minds.

The story behind these assets seems unbreakable, whether they meet earnings expectations or not. If a stock’s price does not decline with negative news about its fundamentals, this can be a warning sign that the asset is overvalued.

Avoiding Asset Bubbles

While an asset bubble can have a variety of different causes, the key sign to look out for is irrational exuberance. The most challenging part of assessing asset bubbles while they are happening is predicting when they will burst.

One way to avoid investing in a bubble is to not invest if you don’t believe the underlying value of an asset justifies the mania.

Another way investors commonly help protect their portfolios from asset bubbles is by maintaining a diversified portfolio. Diversified asset allocation is known as one of the best methods to help de-risk your portfolio because even if an asset bubble bursts and impacts a part of your portfolio,  the overall impact on your investments can still be offset by investments in other assets, industries, and time horizons. Investing in non-correlated assets can help to mute volatility across your portfolio.

This material is provided for informational and educational purposes only.  It is not intended to be investment advice and should not be relied on to form the basis of an investment decision.