DEFINITION of 'Bubble Theory'

A financial school of thought that believes in the development of bubbles: a rapid rise in the market prices of an asset class, far above its true values, that is identifiable by its feverish nature – an "irrational exuberance,"  as former Federal Reserve Chairman Alan Greenspan famously characterized it. Under the bubble theory, large overvaluations of assets can persist for years, but eventually burst, causing prices to precipitously decline before stabilizing at more reasonable levels.

Bubbles can develop in securities, commodities, industries, stock markets, housing markets, and other economic sectors whenever something causes investors to eagerly pursue profits beyond a reasonable hope of return.

BREAKING DOWN 'Bubble Theory'

In the simplest terms, a bubble is an overheated market in which there are too many buyers who are too keen to buy. As a result, prices rise way too fast, and this situation becomes unsustainable. Eventually, some people realize this and start to sell out. The whole process goes into reverse equally rapidly, and the bubble bursts, with people selling in panic so that prices plunge. Those who entered the market late in the process suffer substantial losses in particular.

Identifying bubbles is an endeavor on which investors spend considerable time and energy, and for good reason. When bubbles are forming, resources flow to areas of rapid growth. When the bubble bursts, resources move away.

Famous Financial Bubbles

One of the first, and most famous examples, of an asset bubble was the "tulip mania" in the Netherlands during the 1630s. More contemporary examples include the the U.S. real estate bubble in the early 21st century (which popped dramatically with the subprime mortgage meltdown in 2008-09) and the dotcom bubble in the late 1990s and early 2000s. Spurred on by new technology, investors bought tech stocks at increasing prices. They believed those prices would continue to climb as internet companies built their customer bases. Eventually, investors lost confidence and a sell-off ensued, leading to a market correction. The dotcom bubble burst, leaving many investors holding stocks that had little value.

Popping the Bubble Theory

The bubble theory is controversial among those who subscribe to the efficient market hypothesis (EMH). Strictly speaking, EMH would argue that bubbles don't really exist. The hypothesis, whose core tenet revolves around the idea of market efficiency, states that asset prices reflect their true economic value because information is shared among market participants and rapidly incorporated into the stock price. There are no other factors underlying price changes, such as irrationality or behavioral biases. In essence, then, the market price is an accurate reflection of value, and a bubble is simply a notable change in the fundamental expectations about an asset's returns.

But, assuming that bubbles can and do occur, EMH theorists doubt they can be predicted: Market participants are rational, they argue, and so they would not buy into a bubble if its overvaluations were readily identifiable. If they did recognize mispricing, these theorists argue, savvy investors would sell the inflated asset, anticipating (and by their actions, causing) its decline back to true value. Therefore, EMH argues, bubbles can really only be identified in hindsight.

Identifying Bubbles

Other economic theorists and financial professionals disagree. Some bubbles are certainly more visible than others, and some people are in a better position to see them than others. But all bubbles are identifiable, this group says – and before they burst, too.

In the stock markets and many others, simple price rises and various more complex ratios and indicators can be seen to change unhealthily. In property markets, there might be reports of prices increasing by 5% (or even much more) in one month. In other, less publicized markets, such as those for bonds, certain commodities and currencies, may not be so obvious, but there will be indicators.

Whatever the market, even simple charts, basic patterns of buyer or seller behavior and media reports can reveal radical changes within a short time frame. These are clear danger signs. In other words, if you look for signs of overheating, they are there. Professionals in the field, such as bankers and brokers, do know about the state of the market. And if they really don't, they should be in some other line of work. Euphoric investor behavior and all those other radical changes mentioned above will certainly not go unnoticed. Of course, there can be exceptional situations in which bubbles prematurely or very late, but generalized allegations that a bubble was out there lurking invisibly behind the scenes from start to finish are just plain false.

Why a Blind Eye?

The basic problem is that there is money to be made out of a bubble, particularly on the selling side. A bubble is really a great thing for the financial services industry, which naturally wants to carry on making money as long as it can. It can sell of lot of the bubbling asset for substantial gains, and when the bubble bursts, it is the investors who lose out, rather than the brokers. As for the regulators and policy makers, they can make themselves very unpopular with the financial services industry by trying to cool down a sizzling money-machine. And indeed, it is very hard to time the exact timing of the burst. So, naysayers tend to keep quiet until too late.

Investors themselves sometimes get greedy and do not sell when they should. Trying to stay in a red-hot market till the peak is not only dangerous, it is one of the worst and most imprudent of all risks. When such markets drop, it is alarmingly rapid and generally too late to exit without big losses. Other investors simply rely on their brokers or money managers to warn them, and, for the reasons given above, the warning may never come at any point. All too often, trusting private investors only know the bubble has burst on them personally, when the monthly brokerage statement arrives in the mail and the losses are plain to see.

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