What is an asset bubble?

We have had numerous asset bubbles in the past. These include the tulip mania, the US housing bubble, and the dot-com bubble. All these asset classes rose in value due to irrational exuberance. However, the same characteristics were in place which drove up the prices. In this article we discuss the reasons for asset bubbles, the reasons for the asset price falls, and the implications of price devaluation.

What is an asset bubble?

Asset bubbles occur when the asset is priced at a level which is well above the intrinsic value. This intrinsic value is the fundamental value of an asset. This value is determined by identifying what the asset is worth and not what the market thinks it is worth.

How is an asset bubble created?

Economic Growth: When there is a prolonged period of economic growth, then investors may be misled into thinking that asset prices will continue to go up.

Herd mentality: When prices go up people think the asset price will continue to go up and want to get exposure in that asset to profit from rising prices.

Easy Credit: With interest rates being very low, debt is cheaper for consumers to obtain and banks are more willing to lend money. This gives people access to funds which they can put into assets which attributes to the rising prices.

What causes an asset bubble to burst?

There is usually an event that occurs which causes the asset to fall. This could be a change in regulatory conditions or an event which causes sentiment of that asset to become negative.

When asset values start to fall, investors who have borrowed funds start to panic first and sell as they may be paying off loans on an asset with a decreasing capital value. This causes the asset price to fall further and other investors follow with more selling.

Do asset bubbles cause recessions?

This depends on the asset itself.  The 2008 recession in the US was caused by the housing bubble. People were buying houses they could not afford with the assistance of low interest rates and lax lending standards. When interest rates rose on these loans, home owners were unable to repay the interest repayments and this cause loan defaults which then affected the banking system as banks and hedge funds brought mortgage-backed securities on the secondary market.

Lauren Hua is a private client adviser at Fairmont Equities.

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