Asset Bubbles: Causes and Trends

Learn how to recognize the signs of an asset bubble

Hand holding needle about to pop bubble with dollar sign inside of it.
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An asset bubble occurs when assets such as housing, stocks, or ​gold dramatically rise in price over a short period, not caused by the value of the product. The hallmark of a bubble is irrational exuberance—a phenomenon when everyone seems to be buying up a particular asset without necessarily having a good reason. When investors flock to an asset class, such as real estate, its demand and price increase.

During a bubble, investors continue to bid up the price of an asset beyond any real, sustainable value. Eventually, the bubble "bursts" when prices crash and demand falls. The outcomes are often reduced business and household spending and a potential decline in the economy. Understanding the causes and historical trends of asset bubbles can keep you from contributing and falling victim to a future one.

Note

Irrational exuberance is a common sign of an ongoing asset bubble.

Causes of an Asset Bubble

Three chief conditions contribute to irrational exuberance and subsequent asset inflation:

  • Low interest rates: Low interest rates make it easy to borrow money cheaply, which boosts investment spending. However, investors cannot receive a good return on their investments at these rates, so they move their money into higher-yield, higher-risk asset classes, spiking asset prices.   
  • Demand-pull inflation: This occurs when buyers' demand for an asset exceeds the available supply. The sellers of the asset then raise the prices.
  • Asset shortage: This occurs when investors think that there is not enough of a given asset to go around. Such shortages make asset bubbles more likely, because the imbalance between supply and demand leads prices to rise beyond the asset's value.

Examples of Asset Bubbles

Several asset bubbles have taken place in the 21st century, including the following.

2005 Housing Bubble

The 2005 real estate bubble was fueled by credit default swaps that were used to insure derivatives such as mortgage-backed securities and collateralized debt obligations (CDOs). 

Hedge fund managers created a huge demand for these supposedly risk-free securities, which in turn boosted 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 and increased home prices.

When the homebuilders finally caught up with demand, housing prices had started to fall in 2006. That burst the asset bubble and caused the subprime mortgage crisis in 2007, which in turn led to the global financial crisis in 2008.

2008 Oil Asset Bubble

The asset bubble that occurred between 2007 and 2008 affected oil prices. Global production of oil fell from 2005 to 2007, in part because of a decline in depleted oil fields in Saudi Arabia. At the same time, demand for oil grew. China was one of the biggest consumers, using 870,000 barrels of oil a day in 2007.

The below-average oil supply led to dramatic price increases between late 2007 and the first half of 2008. By July 2008, oil prices had reached a record of $145 per barrel.

2011 Gold Asset Bubble

Gold prices started rising in 2008. 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 speculation continued, and prices rose for three more years.

The commodity reached a record high of $1,917.90 per ounce in August 2011. However, it fell below $1,600 in 2012.

2012 Treasury Notes Bubble

To boost the economy following the global financial crisis, the Federal Reserve started a new round of an economic stimulus program known as "quantitative easing," buying $85 billion per month in treasuries in September 2012, reducing interest rates. Yield rates followed suit; on June 1, 2012, yields on 10-year Treasury notes closed at 1.47%.

That same day, investors sold off stocks amid fears of high unemployment and the worsening of the eurozone debt crisis, driving the Dow down 275 points. They turned to safe-haven Treasury notes instead.

By 2013, interest rates started to rise as the Fed hinted that it would begin winding down its purchases of Treasury notes in September. Treasury yields rose about 75% between May and July. The Federal Reserve postponed its intended course of action when the government shut down in October. Therefore, the yield on the 10-year Treasury remained at around 2.5% to 2.8%. 

2013 Stock Market Bubble

The stock market took off in 2013. The Dow Jones Industrial Average experienced a gain of 26.50%—its largest in 18 years. The S&P had its best year since 1997, posting gains of 32.39%. Rising corporate profits—a product of cost-cutting and productivity increases—drove up stock prices. However, companies stockpiled the earnings rather than reinvesting them.

Demand for many consumer products was also weak, because unemployment was still high (above 7%), and wages were low. In May, the Federal Reserve hinted that it would taper quantitative easing, which put a brief damper on the market. However, more pronounced economic weakening occurred in early 2014; stocks fell sharply in January. The high value of the U.S. dollar relative to regional currencies played a role in lower returns for U.S. investors.

Although the stock market rallied in February, GDP growth for the first quarter stood at an annualized rate of -0.29%.

2014 and 2015 U.S. Dollar Bubble

In late October 2014, when the Federal Reserve announced that quantitative easing would end, Forex traders stampeded into the dollar, causing it to soar.

At the same time, the European Central Bank stated that it would start quantitative easing, so U.S. GDP improved to an annualized rate of 4.6%. These developments reflected American economic strength combined with weakness in the European Union and emerging markets, especially China.

The strong dollar hurt exports, which reduced U.S. GDP in 2014 and 2015. It also aggravated a drop in oil prices, which fell to a six-year low in the third quarter of 2015.

2017 Bitcoin Asset Bubble

Bitcoin is a digital currency—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. Its stratospheric rise in 2017 was in part because Japan's Financial Services Agency recognized it as a legitimate payment method. Japanese traders comprise 60% of the entire market.

In 2017, the price of Bitcoin rose over 1300% from its opening price at the start of January to its closing price at the end of December. Its total market value was $16 billion at the beginning of the year and $229 billion by the year's end.

On November 29, 2017, the price of a single Bitcoin reached a record high of over $11,500. Hours later, it fell to around $9,600. 

New Stock Market Asset Bubble

Despite market volatility following recovery from the global financial crisis, historically low interest rates, increased consumer spending and higher business profits, a shift from investment in real estate to stocks, and low inflation and savings rates have contributed to soaring stock prices since 2017.

The Dow rose above 21,000 in mid-2017. While it declined at various points in 2018 amid trade tensions between the U.S. and China, the market subsequently rallied each time. The Dow was over 35,000 as of late November 2021.

Note

When a stock market asset bubble bursts in the form of a market crash, the outcome is often an economic depression.

Emerging Student Loan Bubble

Students have been racking up debt for decades. The typical student took out a loan of between $20,000 and $24,999 in 2018, compared with only $17,172 in 2005. High debt has been accompanied by a high delinquency rate. In 2018, 10% of adults with a bachelor's degree were behind on payments; the rate was 37% for students with associate's degrees.

Some economists fear the burst of this asset bubble above all, because it could have devastating consequences for the next generation. Students with sizable outstanding debt and limited government support may have to delay marriage, starting a family, buying property, or switching to a different career.

Protecting Yourself from Asset Bubbles

While an asset bubble can have a few primary causes, such as low interest rates, demand-pull inflation, and asset shortage, one of the key signs to watch out for is irrational exuberance.

If you think the value of an asset doesn't justify the hysteria, avoid buying it purely because it seems profitable. Often, the price will keep increasing for years. The problem is that it is tough to time asset bubbles and their subsequent bursts.

Instead, opt for 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 occasionally 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.

Work with a qualified financial planner, and you won't get caught up in irrational exuberance and fall prey to asset bubbles.

Frequently Asked Questions (FAQs)

What happens when an asset bubble bursts?

When an asset bubble bursts, the prices for that asset deflate. Depending on how inflated the bubble got before it burst, the sell-off can get quite extreme. For example, the 2005 housing bubble got so extreme that it led to the Great Recession when it finally burst.

When is a price increase not considered an asset bubble?

A price increase isn't an asset bubble when the movement corresponds with an asset's fundamental value. However, it can be difficult to determine an asset's fundamental value and when prices deviate from that value.

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