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Asset Bubble: Get Out, before it Pops - Oct 2020

Updated: Dec 13, 2020

Get out, before it pops

Have you heard about the Asset Bubbles? Oh yes, bubble like “The big short” one! Most of us have read about the Global financial crisis and the bankruptcy filing by Lehman Brothers with $ 619 billion of debt in 2008 as a result of the burst of the US housing bubble. This collapse wiped out $ 10 trillion of global market capitalization in October 2008. Do you know how it all started? Let us dig deep into the phenomenon that led to this crisis. Do you know the situation that arises when the price of an asset in the market keeps rising continuously over and above its fair fundamental value? Yes, we are talking about Asset Bubbles. Before we get into the details of how an asset bubble is formed, what are its causes and consequences, what are the different measures taken to deal with bubbles, and so on, let us first understand what an Asset Bubble means. What is an asset bubble? According to the current economic theory, an asset bubble exists when the market price/value of an asset significantly exceeds its fair price determined by fundamental factors for a prolonged period. Thus, when the price of assets like stocks, bonds, gold, real estate, and commodities rise at a rapid pace without underlying fundamentals such as equally rising demand justifying the spike in prices, it leads to the formation of an asset bubble. This phenomenon was observed during the US housing bubble 2005-06.

Graphical representation of the massive rise in the Home-Price Index amidst the U.S. housing bubble, 2005 What does it take to make an asset bubble? 1.) Expansionary/Accommodative Monetary Policy: An expansionary monetary policy leads to an aggressive increase in the new money supply. Low-interest rates make borrowing cheaper and discourage savings. The large amount of new money supply created as a result of the policy can flow to a higher-yielding, risky asset class, thus spiking up its prices. This spike up in prices leads to more investors to continue buying even at higher levels, thus ultimately leading to the creation of a bubble.

Graphical depiction of asset bubbles created from 1975 to 2008 in the U.S. and their relation to the Federal Funds Rate

2.) Access to abundant liquidity: It has been historically observed that the inflation-targeting monetary policy framework adopted by major central banks has often led to massive asset bubbles. Amidst the widespread economic depression caused by the pandemic globally, it has been observed that all major central banks around the world have slashed interest rates to record low levels and have adopted aggressive policies to create abundant money supply to stimulate demand and inflation in the medium term. This is evident from the increase in the size of the balance sheet of all the central banks. If we look at the figures from July 2019 to July 2020, the balance sheet size of the US federal reserve has increased from $3.8 trillion to a whooping $7 trillion. This enormous liquidity has ultimately resulted in a massive spike in prices across various asset classes like global equities which have provided massive returns in the range of 30-50%.

3.) Leverage: The global financial crisis of 2007-09 showed how excessive leverage/debt levels in the economy and financial system can lead to a major asset bubble. The fact that during the peak of the US housing bubble into 2006, Lehman Brothers had a leverage ratio of 44:1. This meant that if the firm had $1 of its own fund(equity) and $44 of debt, its total capital would be $45. Such excessive leverage levels were created in the system because of the abundant liquidity measures (as discussed above) and liberal regulations post the US dotcom crash of 2000. This facilitated massive investments into instruments like mortgage-backed securities and Collateralized Debt Obligations (CDO) which led to the creation of the U.S housing bubble. 4.) Irrational Exuberance and Herd Mentality of Investors: Irrational exuberance is a phenomenon wherein everyone is buying up a particular asset. In the case of an asset bubble, more retail investors, out of the fear of missing out on gains, keep buying the asset even at rising prices with the objective of short - term gains. This irrational behaviour of investors widens the gap between the intrinsic value of the asset and its actual price, leading to the formation of a bubble. It was observed during the rally in the Indian equity markets in the 1990s. For instance, ACC rose from Rs.200 to Rs.9000 in a quick time and Mazda Industries and Leasing Ltd rallied from Rs.20 to Rs.1600 quickly. What makes a bubble pop?

Following are the stages: 1.) Displacement stage: At the displacement stage, the investors are captivated by a new pattern in the financial system like extremely low-interest rates, and so on. A classic example of the displacement stage is the massive decline in the Federal Funds Rate implemented by the U.S. central bank for 3 years from 6.5% in July 2000 to 1.2% in June 2003. Over this period, rates on the 30-year fixed-rate mortgages fell to a record low of 5.23% leading to the U.S. housing bubble in the subsequent years. 2.) Boom stage: Demand for assets rises initially. Price rise witnesses more momentum as several investors jump in to buy that asset. There is a fear of missing out in the minds of investors and they are willing to buy that asset at any price. This is one of the reasons behind increased speculation attracting a growing number of investors. At this stage, the continuous spike in asset prices attracts widespread media attention. A large number of investors blindly follow the theories and speculations set up by bullish operators. 3.) Euphoria: During the euphoria stage, asset prices escalate at an unbelievable rate and valuations reach unimaginable levels. New valuation metrics are introduced to justify the uninterrupted rise. This stage witnesses the “Greater Fool Theory” wherein the market for the asset has buyers at all times despite the continuous spike in prices. The fact that at the peak of the U.S. dot-com bubble in 2000, the combined value of all technology stocks in the Nasdaq was more than the GDP of most nations signifies how volatile and dangerous the euphoria stage is and how it facilitates the continuous price rise.

Summary of the chain of events in the rise and fall of the U.S. technology index Nasdaq amidst the Dot Com Bubble, 1990-2000 4.) Profit-Taking stage: This is the stage wherein a few smart investors start paying attention to the continuous warnings of overvaluation and irrational rise in the prices of the asset. As a result, the investors start squaring off their positions to book their profits. As we saw in “The Big Short”, a group of Hedge Fund managers and traders predicted the incoming burst of the US housing market bubble and shorted excessively against the market through instruments like CDS. 5.) Panic stage: As soon as the prices start revising downwards, investors face the twin challenge of continuous fall in the value of the holdings and margin calls. As a result of the supply exceeding demand for the asset, the prices keep declining and the investors are now ready to sell their holdings at any price. The prime example illustrating this stage was the burst in the bubble of the Indian stock market during 1992 as a result of panic selling which ultimately led to the primary index (Sensex) dropping from 4500 levels to 2500 levels.

Does an asset bubble lead to an economic recession? Historical examples of asset bubbles have shown that they can lead to a widespread economic recession. In the global financial markets, price volatility and fluctuations are very normal. It is normal to see the prices of various assets rise and fall due to the actions of the buyers and sellers in the market. In the long run, prices tend to move towards their fundamental fair value. However, in the case of asset bubbles, prices for a given class of assets or goods overshoot the implied market equilibrium price and remain persistently high and even continues to climb rather than correcting toward the expected equilibrium prices. This happens primarily due to various causes discussed above in this article. One significant fact is that the new units of injected liquidity/money supply first, reach specific areas and people of the financial system and then gradually spread over to the entire economy as the units change hands with time. The early recipients of the new units of money injected are thus able to bid up the prices of the particular assets/class of assets they purchase before the prices of the rest of the goods in the economy show a rise. This Cantillon Effect produces an asset bubble. The prices of the particular asset no longer reflect the true fundamental picture or the actual demand-supply scenario but are driven higher due to the Cantillon Effect of the new money injected into the system. Now, this rapid rise in the price of a particular asset leads to the irrational behaviour of investors. This leads normal people, with little to no experience of investing, to also jump into purchasing the asset. These people are effectively the last recipients of the new money supply injected. The new money supply for these people trickles down through wages, salaries, or business income. However, at this point, the new units of money have spread throughout the economy and thus have little or no capability to continue to push the relative prices of the particular asset up as compared to the other goods in the economy. Thus, realizing that the price of the asset may already have reached its peak and will not be able to further sustain the rise without additional fresh liquidity by the central bank, the early recipients of new money gradually start selling the asset to the latecomers. This causes the bubble to start deflating. There is no new money entering the economy to fuel the bubble price rise leading to lacklustre returns for the latecomers and dampening optimism of a further price rise. The bubble price starts to fall further at this point and without the fresh flow of new money, the bubble ultimately bursts. This sends prices falling dramatically, at the same pace or maybe even faster than the pace of rising. This is the final phase of the Cantillon effect, which not only highlights the change in the relative prices during the rise of the bubble but also signifies the fact that in any bubble, there is a huge amount of real wealth and income that gets transferred from the latecomers to the early recipients of new money who started the bubble in the first place. Since the entire bubble was a result of the new money (fractional reserve credit) created by the central bank and the banking system, the burst of the bubble not only leads to heavy losses to the current holders of the asset but also leads to a process of massive debt deflation thus ultimately bringing down the entire financial system and sending the economy into a recession. Most of the major historical asset bubbles have been a result of the above-mentioned phenomena and have shown the characteristics discussed.

Historical Asset Bubbles followed by a massive economic crisis/recession

Economic recessions have followed an asset bubble. The primary cause is the expansionary monetary policy adopted by the central banks to boost the money supply in the economy to ensure optimal inflation for growth. Asset bubbles in the past have shown that the sole objective of inflation targeting in any monetary policy is not enough to ensure long-term sustainable growth for the economy. Policymakers need to consider financial stability as another critical goal and come up with alternative policies and frameworks like Credit to GDP ratios and macroprudential tools that address the health of the financial system as an important measure to be adopted with the traditional monetary policy instrument and inflation targeting framework. Finishing thoughts Quite a read wasn’t it? But why are we talking about this right now? Are we heading towards the next asset bubble? Well, consider this, while we are still struggling to revive the global economy, markets are inching towards their pre-covid highs. Assets are experiencing enhanced liquidity and are being traded in increasing volumes. Time to square off your position ad hide your money under the mattress? Well, let’s hope not!

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