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23 – Asset Bubbles

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23 - Asset Bubbles

 

 

Asset bubbles are a really interesting situation when they pop up.  They are a really cool study in what happens when mass human psychology gets completely and obsessively out of control.  The attitude is kind of like how the rap artist 50 Cent describes it; “get rich or die trying”!

 

In this Article:

  •         What is an Asset Bubble?
  •         U.S. Housing Market Bubble
  •         The Dot Com Bubble
  •         Cryptocurrency
  •         Commodity Bubbles

 

What is an Asset Bubble?

An asset bubble happens when irrational demand drives up price of a particular asset well beyond what would normally be considered a reasonable price.  This usually happens when investors and speculators buy something just because everyone else is buying it. People seem to forget that carefully analyzing the benefits of buying the particular asset might be a good thing.  Proper due diligence is kind of important isn’t it?

You may have heard this kind of behaviour referred to as the herd mentality.  Get in on the action at any cost is the name of the game!

In the past many recessions have been caused by these asset bubbles forming.  What typically happens is the market sells off sharply when it realizes what is actually happening and that the price paid may not actually be worth it.

These sharp sell offs lead to a severe drop in confidence.  This lack of confidence causes credit markets to cease up because lenders become very suspicious of the value of the assets behind the loans they have made.  Banks will pull back loans and about the ability for the person who borrowed to pay back the debt. The banks basically stop lending because they need to protect their balance sheets from further losses.

“Live to fight another day” and “every man for himself” is the dominant thought process when everyone starts piling out of the risky asset that the bubble is centered around.

 

U.S. Housing Market Bubble

In the United States there was a massive sell off in the housing market.  This was one of the main reasons for the great recession that started in 2007.

Many mortgage lenders were giving out massive loans to people who had absolutely no ability to pay them back.  Some lenders were giving out million dollar loans to people on something called ‘stated income’. This is mind blowing to anyone who understands basic risk and reward.

Stated income basically means that the borrower only had to tell the lender that he or she makes enough money to pay back the loan without actually having to prove their ability to repay the loan.  Can you imagine walking into a bank a telling them you make a million dollars per year, without providing any proof at all, and then asking them for a 5 million dollar loan for a new mansion….and they actually give it to you!!

This is absolutely absurd to even think about for most people.  But this is exactly the kinds of things that were happening all throughout this housing bubble.

These kinds of loans are what we have come to learn are called subprime lending.  This kind of lending is what fuelled the massive price spikes in the housing market.  When the bubble burst it caused a huge influx of houses to hit the market. This huge amount of supply was many multiples beyond the markets natural demand so prices came crashing down to find a new relative fair value.

This was a time in some areas of the United States where houses that were bought for 5 million dollars sold for less than 10% of that by the time the housing market finally found a bottom.

 

The Dot Com Bubble

The Dot Com bubble started around 1997, peaked in 2000, and completed its implosion by 2002.  The bubble revolved around speculative investments in internet companies. Investors got so excited about the future potential and progress of the internet that they indiscriminately bought up any tech company regardless of if they knew how the company was going to make money.

People just didn’t seem to care about whether the tech company was or ever could be profitable in the future.  As long as there was .com at the end of the company’s name they bought it up and bought it up hard. Common sense went completely out the window.

From 1997 to 2000 the NASDAQ composite went up over 500% only to come crashing down all of that and then some.  Many internet stocks went up thousands of percent only to come all the way back down. A huge percentage of those internet stocks went out of business because they simply were never going to offer any value to the world.

 

A simple Google search will lead you down a rabbit hole with all the information and stories from this time that you could ever want.

Now, it wasn’t that the technology was bad.  Obviously, the internet has fundamentally changed the way that we do business and how humans interact with each other.  It was more that when we venture out into uncharted waters there is a lot of exploring we have to do before the sailing becomes smooth.  With the Dot Come bubble the market needed to go through a process of self-discovery to figure out how the internet was going to be used profitably on the world stage.

 

This also meant going through a lot of companies that had no business being a business in the first place.  This is pretty similar to what is happening in the Crypto space which is the next asset bubble we are going to talk about.

 

Cryptocurrency

This is a bubble that is sort of in the making as this is being written in early 2018.  This is an interesting bubble because it has a lot of the same makings as the Dot Com bubble.  It’s not that the technology is bad. Block chain technology has the potential to revolutionize the world in a similar way that the internet did.  However, it seems that we are going through a bit of a similar process of price discovery that we did in the early stages of the internet.

Here is a good article that describes the similarities of the crypto bubble to the Dot Com bubble in an impartial way.

https://medium.com/swlh/how-similar-is-the-crypto-bubble-to-the-dot-com-bubble-bd6f30992e60

Cryptocurrencies, the most commonly known is Bitcoin, have already gone through what most economists would describe as multiple bubbles within a larger bubble.  You can see from the chart below that there have been multiple 50-80% pullbacks in the larger trend that has brought Bitcoin from a few cents to almost $20,000 and now it’s working its way back down.  Time will tell how far it will drop.

The main driver behind these insane moves is rampant speculation that cryptocurrencies will replace regular fiat currency.  Fiat currency is the money that you use to buy stuff wherever you live. The idea is that block chain technology can be used to unify the world with decentralized access to use cryptocurrencies as a method of payment anywhere in the world.

We won’t go any further on Cryptos other than to suggest doing a quick Google search on the terms Cryptocurrencies and Block Chain technology.  You will find a vast amount of information of the pros and cons of both.

 

Commodity Bubbles

Oil price shocks can also be a common hindrance to the economic stability and growth of a nation that is heavily dependent on importing oil.  This can occur when a spike in oil prices cuts into consumer spending power. This also increases business costs which can of course lead to many problems.

People need oil to heat their homes and fill the gas tanks in their cars.  If the price of oil goes up too much it takes away disposable income because people still need the oil regardless of how high the price is.  If people are spending most of their available money on oil then they can’t very well go out and spend on other things which will filter through to almost all areas of the economy.

Of course there are many other bubbles that are noteworthy and super interesting to read about.  The Tulip Mania comes to mind. But hopefully we gave you a few that you can take away as a lesson and recognize an asset bubble in the making so that you can potentially make a couple bucks when one materializes.

 

Up Next:

Whoa, asset bubbles are pretty intense!  Let’s keep the intensity rolling in the next article where we talk about and define a fascinating subject that happens when a central bank does everything completely wrong.  Next up is hyperinflation.

 


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