Protect Yourself from Asset Bubbles by Knowing Their Causes
Recognize the Signs of an Asset Bubble
An asset bubble is when the price of an asset, such as housing, stocks, or gold, become over-inflated. Prices rise quickly over a short period. They are not supported by the underlying demand for the product itself. It's a bubble when investors continue to bid-up the price beyond any real, sustainable value. These price spikes often occur when investors all flock to a particular asset class, such as the stock market, real estate, or commodities. Such a bubble is also called asset inflation.
Three Causes of an Asset Bubble
Low-interest rates are the most frequent cause of an asset bubble. They create an over-expansion of the money supply. Hence, investors can borrow cheaply but cannot receive a good return on their bonds. So they look for another asset class.
The second biggest cause is demand-pull inflation. That's when an asset class suddenly becomes popular. As asset prices rise, everyone wants to get in on the profits. But the consumer price index does not always accurately capture this form of inflation. So policy-makers overlook it.
Third, a supply shortage will aggravate an asset bubble. That's when investors think that there is not enough of the asset to go around. They panic and start buying more before it runs out.
2005 - Housing Bubble Example
An asset bubble occurred in real estate in 2005. Credit default swaps insured derivatives such as mortgage-backed securities. Hedge fund managers created a huge demand for these supposedly risk-free securities — that created demand for the mortgages that backed them.
To meet this demand for mortgages, banks and mortgage brokers offered home loans to just about anyone. That drove up demand for housing, which homebuilders tried to meet. Many people bought homes, not to live in them or even rent them, but just as investments to sell as prices kept rising. When the homebuilders finally caught up with demand, housing prices started to fall in 2006. That burst the asset bubble. It created the subprime mortgage crisis in 2006. That led to the banking credit crisis in 2007 and the global financial crisis in 2008.
2008 - Oil Asset Bubble Example
The asset bubble started in the summer of 2008 with oil prices. Investors got out of the stock market in 2007 and started investing in oil futures. At first, they thought that demand from China would outstrip supply due to a mild shortage in Nigeria. But demand fell that year, due to the recession, while supply increased. That didn't stop the asset bubble from creating high oil prices. They set a record of $143.68 a barrel in July 2008.
2011 - Gold Bubble Example
Gold prices reached a record high of $1,895 an ounce in September 2011. They started rising in 2009, reaching a record high of $1,081 in November. Investors bought gold as a hedge against the global financial crisis, not for its value in producing jewelry or dental fillings. Many thought the global economy would recover quickly. When it didn't, gold prices just kept rising for two more years.
2012 - Treasury Notes Bubble Example
On June 1, 2012, Treasury yields hit a 200-year low. The yield on the 10-year Treasury note briefly hit 1.442 percent during the day, closing at 1.47 percent. The Fed was buying $85 billion a month in treasuries since September 2011, boosting demand (which keeps rates low).
Second, investors were worried about high unemployment and worsening of the eurozone debt crisis. They sold off stocks, driving the Dow down 275 points, and bought the safe-haven U.S. Treasury notes. As a result, mortgage rates also dropped. That helped revive the housing market.
By 2013, interest rates started to rise as the Fed hinted it would begin winding down its purchases of treasury notes in September. Treasury yields rose 75 percent between May and July. The Fed postponed its intended course of action when the government shut down in October. Therefore, the yield on the 10-year Treasury remained between 2.5-2.8 percent.
2013 - Stock Market Example
The stock market took off in 2013. By July, it had gained more points than any year on record. On March 11, the Dow Jones Industrial Average closed at 14,254.38, breaking its previous record of 14,164.43 set on October 9, 2007. On May 7, it broke the 15,000 barriers, closing at 15,056.20, and broke the 16,000 barriers on November 21, closing at 16,009.99. The Dow set its high for the year at 16,576.55 on December 31, 2013.
Price gains rose faster than corporate earnings, which are the underlying driver of stock prices. Companies achieved increases in earnings by cutting costs, not increasing revenue. Demand for many consumer products was weak since unemployment was still high (around 7 percent) and average income levels were low. Investors were more concerned about whether the Fed would taper QE than they were about real economic growth.
2014 and 2015 - U.S. Dollar Bubble
Forex traders stampeded into the dollar, which rose 25 percent between July 2014 and the middle of 2015. It happened because when the U.S. Federal Reserve announced that quantitative easing would end in October. At the same time, the European Central Bank stated it would start QE, and U.S. GDP dramatically improved. All this reflected American economic strength combined with weakness in the European Union and emerging markets, especially China.
The strong dollar hurt exports, lowering U.S. GDP in 2015. It also aggravated a drop in oil prices. That cost jobs in the oil industry. It also threatened the viability of many shale oil companies.
2017 - Bitcoin Asset Bubble
In 2017 Bitcoin rose 955 percent, eclipsing the rise of any previous asset bubble. Its total market value was $16 billion at the beginning of the year. It was $171 billion by mid-December. On November 29, 2017, the price of a single Bitcoin reached a record high of $11,000. Hours later, it fell to $9,500. It started the year at $968.23.
One reason for Bitcoin's rise is that Japan's Financial Services Agency recognized it as a legitimate payment method in April. Japanese traders comprise 60 percent of the entire market. Bitcoin is a digital currency. It is a computer-based form of monetary exchange. No government or central bank controls. manufactures or regulates it. In September 2015, the U.S. Commodity Futures Trading Commission designated Bitcoin as a commodity.
How to Protect Yourself from an Asset Bubble
The hallmark of an asset bubble is irrational exuberance. Almost everyone is buying that asset. For a long time, buying that asset seems profitable. Often the price keeps going up for years.
The problem is that it is tough to time a bubble. As a result, most financial planners recommend a well-diversified portfolio of investments. Diversification means a balanced mix of stocks, bonds, commodities, and even equity in your home. Revisit your asset allocation over time to make sure that it is still balanced. If there is an asset bubble in gold or even housing, it will drive up the percentage you have in that asset class. That's the time to sell.
Work with a qualified financial planner, and you won't get caught up in irrational exuberance and fall prey to an asset bubble.