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What is an Economic Bubble?

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Economic bubbles are an important concept for any investor to grasp because they result in drastic price corrections of a commodity, security, bond, etc. Recent examples include the Dot-Com bubble of the 1990’s or the Housing Bubble of 2008, which kicked off the Great Recession. But what are economic bubbles and why do they form in the first place? Understanding how to spot them is the key strategy for any successful investor who wants to know when to sell an asset or short a stock.

Common Economic Bubble Indicators

Correctly identifying economic bubbles for investing in assets like stocks means paying attention to things like price history, investors, market hype, and put buying.

Price History

Get to know a stock’s pricing trends. Is it inherently volatile or are there other factors like climate change, political upheavals, governmental regulations that have caused its price to spike in the past? Price spikes may have less to do with investor euphoria than common external factors.

Investors

Another consideration is who is investing. Top investors are likely the first ones to arrive, followed by less knowledgeable ones looking to take advantage. Inexperienced investors tend to have less strategy and make more impulsive decisions, which can drive up the price and create a bubble. Once your armchair investor starts to get in the game, it may be time to get out.

Market Hype

Economic bubbles are usually preceded by unusual investor excitement, media coverage, wild claims, and other such hype. Separate such noise from the fundamentals of the stock and the company. Stick to reputable experts who work in the market every day and take their advice.

Options Trading

An increase in call buying suggests elevated speculation and is generally a sign that investors are overly optimistic on future stock price appreciation. A decrease in put buying suggest an elevated level of complacency, where investors see little need to insure their portfolio against the possibility of stock prices falling.

General Definition of an Economic Bubble

An economic bubble is formed when central banks hold interest rates artificially low, resulting in over-priced assets, such as stocks, bonds, and real estate, a miss allocation of resources, excess speculation, consumption and borrowing, and insufficient savings.   Inevitably rising consumer prices will force interest rates to rise, exposing the problems created during the bubble.

When the bubble pops, over-valued asset prices collapse, and the economy enters recession as the mistakes and misallocations made during the bubble years are corrected. The further interest rates are kept below their natural level, and the longer they are held there, the more mistakes and misallocations will be made, and the more sever will be the recession necessary to correct them.

Low Interest Rates Inflators

When central bankers artificially lower interest rates, it lowers the cost of borrowing capital for individuals and business. Low or even negative interest rates also reduce incentive to save. Instead of keeping money in banks, individuals begin moving their wealth into more speculative investments like the stock market. More credit means more speculation and prices can be pushed beyond reasonable levels. Low borrowing costs gives people more capital to invest, which can result in misallocated of resources, bad investments, and over-speculations. Capital begins flowing into the bubble making them even larger.

Once prices become unsustainable, an asset selloff begins and the economic bubble begins to deflate. Bad investments are then quickly sold for less than their original costs. The result is severe market volatility and contraction of credit and the money supply. Resources that previously flooded into the bubble begin to flow out to other investments.

The Federal Reserve’s Impact

Because the Fed controls the federal funds rate, it exerts an enormous power on interest rates, and consequently, the formation of bubbles. Since the 2008 financial crisis, the Fed has kept interest rates at historic lows for nearly a decade. The implications for the economy are negative. With little incentive to keep their money in zero-interest savings accounts, more people have been moving to invest in securities. Recent stock market records like the Dow Jones highest closing record are seen by many as having all the hallmarks of a stock market bubble in the making.

Why doesn’t the Fed fear low interest rates? For one, most current Federal Reserve presidents are Keynesian economists.  To them the most important thing to keep the economy growing is ensuring credit flows easily to consumers and investors. So the Fed sees inflation as good, despite the fact that it devalues the currency, inflating asset bubbles that inevitable burst, increases the cost of living, and lowers the standard of living of the nation. Real credit must come from under-consumption and savings, and cannot be conjured out of thin air by a central bank without dire economic consequences.

Driving Off the Economic Cliff

Economic bubbles occur from a misallocation of savings, spending, and investments. Savings and wealth creation are the best ways to ensure rational investment. It makes sense that easy credit can promote bad investments, while an individual or businesses savings are more apt to be protected through careful market analysis and investment.

Both over-speculation and easy credit were key factors in the 2008 housing bubble. Investors were convinced prices would continue to rise, and consumers borrowed more than they could afford to repay. There was an imbalance between savings and investment for both homeowners, who were upside-down in their mortgages, and investors who were bidding up housing prices beyond their true value.

Some economists are seeing similarities between the beginnings of the housing bubble and the current situation within the auto market. Record levels of car owners are upside down with their auto loans, owning more than their cars are worth. Easy credit and low introductory interest rates are setting many consumers up for failure. Additionally, car loan debt is being bundled together and sold to investors in a similar way subprime loans were sold for bundled housing debt.

The Fed continues to keep raising interest rates at historic lows. Future rate hikes, when they come, are likely to continue to be intermittent and insignificant. Inflation, however, is ramping up and the dollar is loosing purchasing power while the stock markets continue to set record highs.

Safe haven investments like buying gold and silver are effective ways to combat inflation and preserve your wealth.
 

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