Asset Bubbles

An asset bubble is a situation where the price of an asset rises to levels that are unjustified by the underlying fundamentals. When an asset bubble pops, the prices of the assets involved typically fall dramatically. We will discuss the top 5 signs that we are in the midst of an asset bubble. We will also provide examples of past bubbles and beginning signs of the bubble bursting so that we can be better prepared for the next one, or navigate the one we are in!

Signs of an Asset Bubble Forming

Sign #1 

The first sign that we are in the midst of an asset bubble is if the prices of the assets involved are rising at an unprecedented rate. For example, during the dot-com bubble, the prices of tech stocks were rising at a rate that had never been seen before. This rapid price appreciation is often not justified by the underlying fundamentals of the asset. This can be calculated by looking at the price-to-earnings ratio, which is a measure of how expensive a stock is. If the ratio is rising faster than the earnings of the company, it could be a sign that we are in an asset bubble. The price-to-earnings ratio in Q4 of 2021 was the highest it had been since the dot-com bubble!

Sign # 2

The second sign of an asset bubble is if there is excessive leverage involved. This means that people are borrowing money to buy assets, which can drive up the prices even further. This was the case during the US housing bubble, where people were taking out mortgages they could not afford in order to purchase homes. When the prices of homes stopped rising, many people were left with debt they could not repay, and this led to the financial crisis of 2008. Interest rates and unemployment were the first signs that the housing bubble was about to burst. When we have a spike in interest rates it makes the cost of leverage go up, therefor investors and banks must sell assets that are not returning more than the cost to carry the leverage. 

Sign # 3

The third sign of an asset bubble is if there is a lot of speculation involved. This means that people are buying assets not because they believe in the long-term fundamentals, but because they think they can sell them to someone else at a higher price. This was the case during the dot-com bubble, where people were buying tech stocks not because they believed in the companies, but because they thought they could sell them to someone else at a higher price. This was also clear in the recent crypto craze, where people were buying Bitcoin and other cryptocurrencies not because they believed in the technology, but because they thought the prices would continue to go up.

Sign # 4

The fourth sign of an asset bubble is if there is a lot of fraud involved. This can be difficult to spot, but it is often the case that when there is a lot of fraud involved, the prices of the assets involved will eventually come crashing down. 

Sign # 5

The fifth and final sign of an asset bubble is if there is a lack of liquidity. This means that it is difficult to buy or sell the assets involved. This can be a problem if the prices of the assets start to fall, as people will be stuck holding them. This was the case during the dot-com bubble, where many people were unable to sell their tech stocks as the prices started to fall.

Examples of Bubbles in History.

The Mississippi bubble was caused by a French financial scheme, which came crashing down.  France was gravely in debt, and a Scotish financier and outlaw John Law convinced the Duke of Orleans, the regent of Louis XV, that he had a solution.  They overstated the wealth of Louisiana, sold shares to the Mississippi company (which had been conveniently granted a 25 year monopoly of all the trade between the West Indes and France).  The profits generated by the shares were paid out in paper notes, and that way France was able to keep the gold collected from the share sales.  This currency trickery worked until the Banque Royale had to admit that the amount of paper currency it had issued was more than the gold and silver reserves that it held.  As the shares reached their peak and stockholders began selling, the money supply in France doubled. Inflation hit 23%.  The bank was forced to stop payment when people began trying to convert their shares into gold and silver in huge numbers.  Share prices dropped to 25% of where they were at the high.

The dot-com bubble was a period of economic growth in the late 1990s and early 2000s. This was due to the large influx of people and money into the tech industry, which led to speculation in tech stocks. This eventually led to the collapse of the bubble.

The US housing bubble was a period of economic growth in the early 2000s. This was due to the large influx of people and money into the housing market, which led to speculation in home prices. This eventually led to the collapse of the bubble.

Signs of an Asset Bubble Bursting

While asset bubbles can lead to economic downturns, they are not always a bad thing. Asset bubbles can also lead to periods of economic growth. For example, the dot-com bubble led to the development of many new technologies that we use today, such as the internet and social media. So while asset bubbles can be dangerous, they can also lead to innovation and economic growth. 

Sign #1 

The first sign of an asset bubble bursting is usually a spike in interest rates. When interest rates rise, the cost of borrowing money goes up. This makes it more difficult for investors and banks to buy assets, as they must now sell other assets to pay off the debt. 

Sign #2

The second sign of an asset bubble bursting is usually a decrease in the price of the asset. This happens because when interest rates rise, the demand for the asset decreases. This leads to a decrease in the price of the asset. 

Sign #3

The third sign of an asset bubble bursting is usually an increase in the number of defaults. This happens because when the prices of assets fall, people are no longer able to afford the payments. This leads to an increase in the number of defaults. 

Sign #4 

The fourth sign of an asset bubble bursting is usually a decrease in the amount of lending. This happens because when the prices of assets fall, lenders are no longer willing to lend money. This leads to a decrease in the amount of lending. The mortgage availability index is a great indicator of banks' willingness to lend. 

Sign #5 

The fifth and final sign of an asset bubble bursting is usually a recession. This happens because when the prices of assets fall, people lose money and stop spending. This leads to a decrease in economic activity and a recession.

Wrap Up

It is important to be aware of these signs so that we can better prepare for the next one! One of the best ways to protect ourselves during an asset bubble is to diversify our investments. This means that we should not put all of our money into one asset, such as the stock market. Instead, we should spread our money across different assets, such as bonds, real estate, and gold. The Sleep Well Portfolio and A.W.A.K.E use macroeconomic data to detect risk in asset classes. When macroeconomic models are used in conjunction with diversification they can greatly enhance return vs risk while avoiding the most painful part of asset bubbles.

May your assets grow, and you Sleep Well,

SWP Team