What’s a Bubble? Understanding Financial Mania

You may have heard the term bubble when it comes to finance and investing. Maybe you’ve heard it in the last few weeks. A few headlines from recent news articles include “Stocks, Bonds, Real Estate in a Bubble, says investor Grantham” and “Bitcoin May Slide Below $30,000 as the Crypto Bubble Begins to Burst.” While by no means is this post intended to suggest that we are currently in an asset bubble — only time will tell if that is the case — we can take a look at the history of bubbles and what exactly a “bubble” entails.

Many historians agree that one of the first bubbles in history was the Dutch tulip bulb bubble of the 1600s. Often termed “Tulipmania,” the bubble saw tulip bulb prices soar to as much a six times the average person’s salary. Tulips were first introduced to Western Europe by traders of the Dutch East India company and quickly caught on as a luxury amongst the wealthy. At one point, certain rare tulip bulbs were fetching what would be considered the mid to high six figures in today’s dollars. However, the bubble eventually popped after being built up over the course of the 1630s. By the late 1630s, many tulip bulbs were selling at 1-2% of their peak prices.

Tulip bulbs are among one of the first recognized financial bubbles

What drove the high prices? A mania spread among the Dutch where everyone wanted to get in on the action. Even peasants with little to no money were attempting to trade the bulbs as assets in the city markets that sprung up throughout the country. Historians debate the financial impact of the bubble bursting, but many people were left with tulip bulbs worth little to nothing after paying exorbitant prices for them just months earlier.

Financial Bubbles Defined

So what exactly is a financial bubble? Investopedia defines a bubble as follows:

“A bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. This fast inflation is followed by a quick decrease in value, or a contraction, that is sometimes referred to as a “crash” or a “bubble burst.”

Typically, a bubble is created by a surge in asset prices that is driven by exuberant market behavior. During a bubble, assets typically trade at a price, or within a price range, that greatly exceeds the asset’s intrinsic value (the price does not align with the fundamentals of the asset).”

-Investopedia

Historical Bubbles

A few asset bubbles have occurred historically in the United States that are worth noting. We’ll discuss those below.

The Roaring 20’s

A very notable bubble that many people are aware of was the stock market crash of 1929. The roaring twenties saw a six-fold increase in the valuation of stocks between 1921 and 1929 that came tumbling down on Black Monday (October 28, 1929) when the Dow Jones declined 13 percent. By the end of the crash, the Dow was down nearly 90%. The chart below reflects the rapid rise and decline of stock values in the 1920s and the following depression that occurred.

The Dot Com Bubble

The “Dot Com” bubble is another famous bubble that was the result of rising tech stock prices in the late 1990s. Between 1995 and 2000, the Nasdaq stock index (which consists largely of technology stocks) rose five fold in value. The rise of internet trading and low interest rates drove an expansion that came to an end in 2000. The Nasdaq sank and many companies that had initial public offerings during the period, despite not generating revenue, declared bankruptcy and closed their doors.

The Housing Bubble

The U.S. housing bubble of the mid 2000’s is another bubble worth noting. Easy credit, subprime mortgages, and the ability of banks to sell mortgages as financial instruments at a profit drove a massive increase in housing prices that came to a halt in 2008. People with little to no credit history and poor credit were able to purchase homes that were well beyond their purchasing power… but the market had kept going up. Between 2008 and 2010, millions foreclosed on their homes and residential real estate values dropped by as much as 50% in some markets. The crash led to the Great Recession and massive reform in lending practices for residential loans.

We hope that you enjoyed learning about bubbles!

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