Asset Bubble

An asset bubble is a sustained rise in the price of an asset, or a whole class of assets, well beyond what its fundamentals support, held up by the expectation that the price will continue to climb. Fundamentals here means the things that ultimately pay an owner: a company's future dividends and earnings, a property's rents, a bond's interest. William Dudley, then president of the Federal Reserve Bank of New York, gave a working definition in a 2010 speech: "By an asset bubble, I mean price increases (or declines) that become unmoored from fundamental valuations." The term is a description economists and policymakers use, and it is applied with far more confidence after a collapse than before one. A housing bubble is the same thing in the market for homes.

Why a bubble is hard to see from inside. Bernanke, then a Federal Reserve governor, explained the difficulty in 2002: "Though the price of (say) a share of stock is readily observable, the corresponding fundamentals — such as the dividends that investors expect to receive and the risk premium that they require to hold the stock — are generally not observable, even after the fact." Prices can rise for good reasons, and some of a boom may be justified. Looking back at the late 1990s, he judged that "at least some of the run-up in stock prices in the latter 1990s was apparently justified by fundamentals," and added that pure bubbles, "increases in asset prices that are 100 percent air," are in his view rare. The same caution runs through our page on housing bubbles: not every large rise is a bubble.

A pattern one central banker described. In his 2010 speech Dudley said that bubbles "are idiosyncratic in terms of their causes, institutional features, duration and severity," but "often share several significant features." In his account an innovation first changes the value of some assets "in a meaningful, but uncertain way," and the uncertainty about fair value fuels the rise. A surge of real economic activity in the affected sector follows, reinforcing the sense that "this time is different." Feedback loops then sustain the belief system behind the high prices, and the rise is easier to sustain when the asset is hard to sell short. His examples included the technology stock boom of the late 1990s, which coincided with the spread of the Internet, and "the credit and housing price bubble and crash of recent years." It is one official's description of recurring features, not a law that every bubble follows.

How the Federal Reserve frames it. The Fed's Financial Stability Report tracks what it calls valuation pressures, which "arise when asset prices are high relative to economic fundamentals or historical norms," noting that they "may increase the possibility of outsized drops in asset prices." That framing is the useful one for an investor too: a question of how far prices sit from fundamentals, rather than a yes-or-no verdict.

Who gets hurt, and how. A bubble's cost arrives when prices fall back toward fundamentals. Bernanke noted that the decline in stock values after March 2000 "vaporized trillions of dollars in wealth." Losses are deepest for people who bought near the top, borrowed to buy, or concentrated their money in the asset at the center of the boom. The behavioral side of the story, the pull of rising prices and of what everyone else is buying, is covered by herd mentality and fear of missing out.

In a typical sequence, a genuine development raises the value of some assets, prices rise, the rise draws in buyers who are paying mainly for further increases, and the price moves further from what the asset earns. When new buying slows, the expectation that held prices up weakens and prices fall, often faster than they rose.

Consider an example with made-up numbers, showing why the arithmetic of a bubble is harsh on late or concentrated buyers. Lucinda puts $30,000 into a narrow group of stocks at the center of a boom, and the holding triples to $90,000. Encouraged, she adds another $30,000, bringing her stake to $120,000. The boom then ends and the group falls 75%, to $30,000. A 75% fall after a 200% rise leaves the original money 25% lower than it started ($30,000 × 3 × 0.25 = $22,500), and because she bought more near the top she has $30,000 left from $60,000 put in. A diversified portfolio holding the same stocks as one small part would have felt the fall, but far less of it.

Pros (of understanding the concept)

• Explains why prices can run far ahead of earnings or rents, and why they can fall back sharply.
• Encourages asking what an asset produces, rather than relying on its recent price rise.
• Shows why diversification and avoiding heavy borrowing matter most when one asset dominates the news.

Cons (of applying it in practice)

• A bubble cannot be identified with confidence while it is happening, so calling one is a guess.
• A rise that looks like a bubble may be justified by fundamentals, and selling out early can be costly.
• A bubble can run much longer than a skeptic expects, and timing its end is rarely possible.