Economic bubbles and why investors should be wary

An economic bubble occurs when the price of an asset is overinflated and overvalued in comparison to its true value. The term “bubble” is a metaphor that originated in the early 18th century following the British South Sea Bubble. Due to prices being “inflated and fragile” the term bubble was used to describe the individual company themselves, rather than the underlying crisis as it is today.

Bubbles are caused by a number of different reasons, often the “fear of missing out” is a major contributor as investors throw caution to the wind and flood to assets rapidly increasing in price, looking to make short term gains. Other factors range from misuse of monetary policy altering interest rates, to over expectation of the performance of an asset, in particular if there is major anticipation of a new invention/product.

Bubbles are both a huge opportunity for investors, as well as a big risk. Buying and selling at the right time can see exacerbated profits in the short run, with those who identify a bubble early and take profits known as the “smart money”. If the bubble bursts prior to market exit, losses can pile up significantly faster than profits were made. They can burst very easily, often minor events such as an institution selling their asset, or even a negative article can cause a market to turn from bullish to bearish in an instant. Panic sellers drive the price down as those who missed the boat on profit-taking look to minimize losses.

There are different types of economic bubbles. “Market bubbles” occur when an entire market sees a rapid increase in price, such as the 2008 housing market bubble in America. “Commodity bubbles” are when an individual commodity’s price is inflated such as the first-ever recognised bubble, the tulip bubble of 1636. “Stock market bubbles” occur when investors drive stock prices far beyond what their fundamental values suggest they should be.

The most famous example of this was the dot-com bubble from 1995-2000 in which the Nasdaq market index grew by 400%, before a subsequent 78% drop from its peak.

“Credit bubbles” occur when there is an inflated amount of borrowing in an economy to fund spending. If enough consumers default on their loan (do/cannot pay it back), banks risk bankruptcy as seen with Lehman Brothers in 2008.

In any given year there can be hundreds of bubbles, from a fidget spinner bubble in 2017 to the recent GameStop saga which saw its price rocket over 1600% in the space of 2 weeks before an 87% fall from its peak less than a month later.

The bubble discussion currently drawing the most attention is that of Bitcoin. In late 2017, Bitcoin saw highs of $19,783.06 before falling to under $3,000 a year later due to lack of investor confidence. This lack of confidence was mainly caused by negative news such as rumours of South Korea preparing to ban trading of cryptocurrency which saw Bitcoin fall by 12%.

Fast track to 2021 and Bitcoin recently reached a new high of just over $57,000. The fundamental reason for the rise in Bitcoins price is its growing use as a payment method, Microsoft for example allow the use of Bitcoin to top up an account balance. Major corporations are investing in the cryptocurrency, and there has been an increase in influencers worldwide that have flocked to spread the word of Bitcoin on social media, as well as the up-and-coming Ethereum (valued at $1,497 as of writing). ARK invest’s Cathie Wood recently stated she sees Bitcoin hitting a $1trillion market capitalization in the future.

The fundamental concern for Bitcoin stakeholders is that its price is held up by market demand, thus negative news can lead to vastly volatile periods as seen by the recent February 2021 selloff.

For it to be a sustainable form of currency it needs relative price stability which has led to contrasting opinions as to whether or not bitcoin is the start of the next generation of currency, or one of the largest bubbles in recorded history waiting to crash.