Identifying Speculative Bubbles and Its Effect on Markets

Speculation plays an interesting role in economics and one that drastically affects markets. If you ever see “speculation” in this context, be sure to pay attention. It is the literal difference between fact and opinion playing with your money. Identifying what are called speculative bubbles helps you follow market trends and make smarter investment decisions. It also tells you when you should raise your eyebrows and look into whose opinion is calling the shots behind the scenes. Suspicion aside, let’s find out how to look for these bubbles.

What is a Speculative Bubble?

A speculative bubble is a sudden increase in the price of an asset, asset class, or industry due to mere speculation, not facts. It often happens when there is an overestimation of factors that may raise asset values, including growth projections and price appreciation.

Due to such speculation, trading volumes soar, and more investors are attracted to these exaggerated expectations. Buyers outnumber sellers, and prices increase far beyond values derived from objective, verifiable information.

The bubble comes full circle only when prices have returned to normal. This period is called a “pop.” Usually, investors scramble to sell investments out of fear of losses.

Recognizing a Speculative Bubble

What are the signs of an emerging speculative bubble?

Excessive and Unfounded Enthusiasm

One of the most telling signs of a bubble is when market participants start ignoring the financial market’s traditional rules. They are extremely optimistic about an asset class’s future performance and disregard any vertical limitations in value growth. This is usually because of “revolutionary technologies.”

Entry of Speculators

Another sure indication of a bubble is when the market floods with speculators. These people have almost zero expertise in the technology or asset classes they are concerned with and are driven only by profit from short-term bets on price development. An example of this is cryptocurrencies. They may make a lot of money from a big bubble until it bursts.

Fast-Soaring Prices

One thing about a bubble is that speculators shift from one asset class segment to another very quickly. This takes attention away from long-term investments and pushes prices higher and faster.

Bitcoin’s prices go up at increasingly shorter intervals and couldn’t be a better example of a bubble scenario. Currently, one bitcoin is worth over $10,000 US. Just five years ago, it was around $200-$300. Unfortunately, many companies, including UBS and JP MorganChase, don’t think it will end well. Still, the bitcoin bubble has yet to pop.

More Publicity

Yet another sign of a speculative bubble is excessive media coverage on an asset class. Once people stop discussing investing, a period of high returns has often simmered down. Professional investors who speculate early on price gains want to exit the asset class and are waiting for the bigger fool to purchase the assets at ridiculously high prices.

With media frenzy, more inexperienced investors dive into the market. People get sucked into the market by alleged professionals who make overly positive market forecasts.

Low-Interest Rates Fueling Speculation

Speculative bubbles flourish best when interest rates are low. After all, interest rates reflect the cost of money, and lower rates mean cheaper money. When the stock market is doing particularly well, professional and amateur investors alike begin to make “safe bets” using borrowed resources.

Investors must be careful. Stock speculation with borrowed money boosts the chances of prices crashing. When share prices drop, banks or lenders will ask for a margin call, and the obligation to add more contributions can bring panicked sales and fast-collapsing prices.

False Low Volatility

Volatility measures how likely there will be fluctuations in an asset class. The market is stable during periods of low volatility unless market participants’ speculations cause low volatility. One good illustration of this phenomenon is the European bond market, where interest rates are extremely low, yet countries have hardly resolved their structural issues.

Riding on Trends

If you see market participants trusting that a drop in prices is unlikely to happen, you’ve got yourself a bubble. In this stage of the bubble, financial institutions take advantage of the thriving market using financial engineering. This involves creating derivative financial products on which people can bet, making it more likely that other markets will be affected when the bubble bursts.

Let’s take America’s real estate crisis of 2007 as an example. This year, the country’s real estate market imploded due to properties being sold to buyers with longstanding poor credit. The banks were aware of the situation, which prompted them to develop securitized mortgages. Securitized mortgage was a new financial product that combined distressed loans and was opened to the international community. With buyers steadfast in their belief that America’s real estate market would keep growing, a real estate bubble formed threw the entire country into a global financial crisis.

Impact of Speculative Bubbles

Asset price bubbles do not directly impact gross domestic product (GDP), but a bubble reflects a change in a specific asset’s current price. Bubbles also indirectly affect the economy, considering that economic agents’ behaviors are partly dependent on price signal changes.

Moreover, economists propose that aggregate spending will go through a “wealth effect” with every rise and fall of asset prices. Based on this premise, increasing asset prices would lead asset holders to use a portion of their brand new wealth to increase their consumption spending. From the viewpoint of a policymaker, a certain industry’s wealth may not be as important as the economy’s general ability to create jobs.

Bubbles are only as important as the amount of damage they can cause the economy’s total health. If the economy can dismiss a bursting bubble and keep growing unhindered, then avoiding bubbles won’t be prioritized. On the other hand, if bubbles cause recessions or financial trouble when they burst, policymakers will put these bubbles on top of their priority list.

A bubble can bring challenges to the financial system if firms holding assets with reducing values enter insolvency or illiquidity. Financial firms are ultimately dependent on one another, and if one cannot perform its obligations, issues can affect all the others that it has been dealing with.

Should trouble escalate to a certain level, it could make it hard for non-financial firms to finance themselves and force them to operate dependently on the general economy. The Great Depression was particularly debilitating because of a banking crisis. Ever since each time financial unrest reared its ugly head, the US Central Bank has acted immediately to keep the unrest from spreading across the markets.