An asset bubble occurs when the price of a financial asset or commodity rises to levels that are well above either historical norms or its intrinsic value, or both. The problem is that since the intrinsic value of an asset can have a very wide range, a bubble is often justified by the flawed assumption that the asset's intrinsic value itself has skyrocketed or, in other words, the asset is fundamentally worth much more than it was in the past. (For more, see: 5 Steps of a Bubble.)
Some bubbles are easier to detect than others, as for instance with stock market bubbles, because traditional valuation metrics can be used to identify extreme overvaluation. For example, an equity index that is trading at a price-to-earnings ratio that is twice the historical average is likely in bubble territory, although more analysis may be needed to make a conclusive determination. Other bubbles are harder to detect, and may only be identified in hindsight.
A common element that runs through most bubbles is the willingness of participants to suspend their disbelief and to steadfastly ignore the increasing clamor of cautionary signals. Another feature of bubbles is that the bigger a bubble, the greater the damage it inflicts when it finally bursts. On that note, we list below five of the biggest asset bubbles in history, three of which have occurred since the late 1980s--a telling sign of the times.
- The Dutch Tulip Bubble: The Tulipmania that gripped Holland in the 1630s is one of the earliest recorded instances of an irrational asset bubble. By one account, tulip prices soared 20-fold between November 1636 and February 1637, before plunging 99% by May 1637, according to former UCLA economics professor Earl A. Thompson. As bubbles typically do, Tulipmania consumed a wide cross-section of the Dutch population, and at its peak, some tulip bulbs commanded prices greater than the prices of luxury homes.
- The South Sea Bubble: The South Sea Bubble was created by a more complex set of circumstances than the Dutch Tulipmania, but has nevertheless gone down in history as another classic example of a financial bubble. The South Sea Company was formed in 1711, and was promised a monopoly by the British government on all trade with the Spanish colonies of South America. Expecting a repeat of the success of the East India Company, which had a flourishing business with India, investors snapped up shares of the South Sea Company. As its directors circulated tall tales of unimaginable riches in the South Seas (present-day South America), shares of the company surged more than eight-fold in 1720, from £128 in January to £1050 in June, before collapsing in subsequent months and causing a severe economic crisis.
- Japan's Real Estate and Stock Market Bubble: In the present era, asset bubbles are sometimes fuelled by overly stimulative monetary policy. The Japanese bubble was a classic example. The yen's 50% surge in the early 1980s triggered a Japanese recession in 1986, and to counter it, the government ushered in a program of monetary and fiscal stimulus. These measures worked so well that they fostered unbridled speculation, resulting in Japanese stocks and urban land values tripling from 1985 to 1989. At the peak of the real estate bubble in 1989, the value of the Imperial Palace grounds in Tokyo was greater than that of the real estate in the entire state of California. The bubble subsequently burst in early 1990, setting the stage for Japan's "lost decades" of the 1990s and early 2000s. (For more, see: From Mrs. Watanabe to Abenomics: The Yen's Wild Ride.)
- The Dot-Com Bubble: For sheer scale and size, few bubbles could match the NASDAQ bubble of the 1990s. The introduction of the Internet triggered a massive wave of speculation in "New Economy" businesses, and as a result, hundreds of dot-com companies achieved multi-billion dollar valuations as soon as they went public. The NASDAQ Composite, home to most of these technology / dot-com companies, soared from a level of under 500 at the beginning of 1990 to a peak of over 5,000 in March 2000. The index crashed shortly thereafter, plunging nearly 80% by October 2002 and triggering a US recession. The Composite eventually reached a new high only in 2015, more than 15 years after its previous peak.
- The US Housing Bubble: Some experts believe that the bursting of the NASDAQ bubble led US investors to pile into real estate in the mistaken belief that this was a much safer asset class. While an index of US house prices nearly doubled from 1996 to 2006, two-thirds of that increase occurred from 2002 to 2006, according to a report from the US Bureau of Labor Statistics. Even as house prices were increasing at a record pace, there were mounting signs of an unsustainable frenzy—rampant mortgage fraud, condo "flipping," houses being bought by sub-prime borrowers, etc. US housing prices peaked in 2006, and then commenced a slide that resulted in the average US house losing one-third of its value by 2009. The US housing boom and bust, and the ripple effects it had on mortgage-backed securities, resulted in an global economic contraction that was the biggest since the 1930s Depression and has come to be known as the "Great Recession."
The Bottom Line
The five bubbles discussed here were among the biggest in history, and hold valuable lessons that should be heeded by all investors.