This illustration shows a bull market blowing bubbles labeled, “Inflated Values,” with many unwary investors reaching for them.

 

“A bubble is where investors buy an asset, not for its fundamental value, but because they plan to resell, at a higher price, to the next investor.”

                                               Peter Kugis-Stanford University

 

     Wall Street bubbles of over evaluation occur every few years for the same reason; people get greedy.

     There is a list of reasons people get greedy and cause the bubbles.

       We see an excessive amount of enthusiasm of big bubbles occurring after there has been great economic growth (railroads in the 1870s, cars and electricity in the 1920s and since 2000, internet/ technology). Bubbles create extreme amounts of enthusiasm, debt, corruption, hope, and speculation.

       This story presents highlights of bubbles in human nature and the reasons for their cause.

Stages of an Economic Bubble

     According to the economist Charles P. Kindleberger, the basic structure of a speculative bubble can be divided into 5 phases:

• Substitution: increased value of an asset
• Takeoff: speculative purchases (buy now/ sell high in the future for a profit)
• Exuberance: a state of unsustainable euphoria.
• Critical stage: begin to see fewer buyers; some begin to sell.
• Pop (crash): prices plummet

Social Psychology of Bubbles

     GREATER FOOL THEORY states that bubbles are driven by the behavior of perennially optimistic market participants (the fools) who buy overvalued assets in anticipation of selling it to speculators (the greater fools) at a much higher price.    

       According to this explanation, the bubbles continue as long as fools can find greater fools to pay for the overvalued asset. The bubbles will end when the greater fool becomes the greatest fool who pays the top price for the overvalued asset and can no longer find another buyer to pay for it at a higher price.

           Extrapolation

       EXTRAPOLATION is projecting historical data into the future; if prices have risen at a certain rate in the past, they will continue to rise at that rate forever. The argument is that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to attempt to continue to capture those same rates of return.

Herding

     Another related explanation used in behavioral finance lies in herd behavior: investors tend to buy or sell in the direction of the market trend. This is sometimes helped by technical analysis that tries to precisely detect those trends and follow them, which creates a self-fulfilling prophecy.

Moral hazard

     Moral hazard is the prospect that a party who is insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.                                                (Source: Wikipedia)

Economic or asset price bubbles are often characterized by one or more of the following reasons:

     ● Unusual changes in single value measures, or relationships among measures (e.g., ratios) relative to their historical levels. For example, in the housing bubble of the 2000s, the housing prices were unusually high relative to income. For stocks, the price to earnings ratios were unusually high.

    ● High debe use (leverage) to purchase assets, such as purchasing stocks on margin or homes with a lower down payment. Higher risk lending and borrowing behavior, such as originating loans to borrowers with lower credit quality scores (e.g., subprime borrowers), combined with adjustable rate mortgages and “interest only” loans.

    ● Rationalizing borrowing, lending and purchase decisions based on expected future price increases rather than the ability of the borrower to repay.

     ● Rationalizing asset prices by thinking “this time it’s different” or “housing prices only go up.”

     ● A large amount of marketing or media coverage related to an asset class.

     ● International trade (current account) imbalances, resulting in an excess of savings over investments, increasing the volatility of capital flow among countries. For example, the flow of savings from Asia to the U.S. was one of the drivers of the 2000s housing bubble.

               ● A lower interest rate environment, which encourages lending and borrowing.  

                                                                   (Source: Wikipedia) 

Human Psychology of Economic Bubbles

      What’s really at the heart of financial bubbles is human behavior. There are four distinct psychological phases of financial bubbles. (see chart below)

Stealth Phase

      The stealth phase is the very early days of an asset when only a relatively few people are aware of it and can see the value… They are the true believers.

Awareness Phase

     Now big money comes calling. Institutional investors take an interest. There is some selloff during the awareness phase by the initial true believers but not enough for anyone to notice. …

 

Mania Phase

     The media notices what is going on and broadcasts it everywhere. Average investors catch wind that something big is happening and they want in. The price starts to rise, and inexperienced investors think it will keep going up forever.

Blow off Phase

     The blowoff phase is the bubble part. The selloff accelerates driven by fear. The fire sale plunges the price of the asset. There are now no greater fools. …”

               (Source: Candice Elliot of listenmoneymatter)