With Google searches of ‘stock market bubble’ at an all-time high in January 2021, financial bubbles are clearly at the forefront of investors’ minds.  However, the complex nature of financial bubbles makes differentiating them from just a bullish market an arduous task. This article will explore financial bubbles, defining what they are and how are they are formed as well as investigating possible methods of prediction.
What are they?
Defining a Financial Bubble is often very difficult to do and has evoked great debate about definition and causation amongst modern economists. With that said, a financial bubble can be defined as when assets (which can vary from commodities to housing to stocks) significantly increase in value over a short period of time. These bubbles conclude with the collapse of the asset’s price leading to large losses for investors who got in too late.
Reasoning behind the original, unforeseen increase ultimately comes down to a rise in demand for those assets. An excellent way to assess how bubbles can be formed is to look at the history books and see what the causes of some of the most notable financial bubbles in history came down to.
Tulip Mania: 1636-1637
The Dutch Tulip Mania is, more often than not, considered the first ever financial bubble. With an affluent and growing middle class, in the mid 1630s the Dutch used rare tulips as a symbol of wealth.  As these tulips grew in popularity, so did their price. Whilst prices rose, so did speculation as much of the market began to see the potential of profiting on buying tulips, selling them at a premium at a later date. Some tulips in the period experienced a 12-fold increase in price whilst others were worth as much as luxury real estate.  All this came to an abrupt end in early February 1637, when fears of market unsustainability and the incoming Black Plague disease led to a dramatic fall in demand. Consequently, the price of tulips fell enormously to virtually nothing.  Whilst not impacting the Dutch economy massively, this mania presents market speculation as a cause behind financial bubbles and the effect that it can have on market behaviour.
The Dot-Com Bubble: 1997-2001
With internet adoption growing exponentially in the 1990s, investors threw money at internet-based companies with promises of extremely high returns in the coming years. The 1990s boasted over 5,700 IPOs, with many of the companies going public hoping to reap the speculated rewards of the internet.  Whilst more and more companies went public, the heavily-technology-based Nasdaq grew by over 400% from 1995 to 2000, as seen on Figure 1. 
However, the hype around internet stocks would begin to crumble away in 2000. An increase in the US interest rate in February 2000 sparked fear of pricier funding for companies. This coincided in March 2000 with the Japanese economy entering into a recession which together triggered a sell off – particularly for technology stocks.  This sell off was intensified when Barron’s (a popular financial magazine) featured a study of the obscene cash burning forgoing at internet-based companies.  Over the next two years, the Nasdaq would fall by 78% compared to its peak, as investor confidence plummeted, and entire fortunes were lost.  The conveniently named dot-com bubble is another example of speculative activity based on little information which caused the price of an asset (in this case the equity of internet-based companies) to skyrocket.
US Housing Bubble: 2006-2008
The US housing market bubble will arguably be the first to pop into people’s heads when financial or ‘market’ bubbles are mentioned. Greater lending from financial institutions throughout the early 2000s as a result of the growth in mortgage backs securities led to huge increases in the prices of real estate. Huge information asymmetries and a lack of adequate information checks exposed both institutions and customers to significant risk. As the desire to lend was seemingly exponential, mortgages began to be awarded to individuals who had no chance of being able to keep up with the required payments.  As mortgage defaults increased, so did the supply of housing on the market leading to huge decreases in the price of real estate. Throughout 2007 and 2008, housing prices would decrease by a whopping 18% and with that, the housing bubble was over. The US housing bubble is evidence of a more institutionally induced bubble which ‘popped’ as the consequences of the excess lending came to the surface.
Predicting a bubble
As renowned investor Warren Buffet put it: ‘A pin lies in wait for every bubble’.  This comment highlights a key characteristic of market bubbles in the sense that, at one point or another, all bubbles have to pop. The harsh consequences for investors and negative externalities for the rest of the economy have meant that a method of detection of financial bubbles has been long sought after. However, it is a very difficult task to do.
One of the biggest issues in predicting market bubbles is finding the difference between them and a bullish market sentiment. Just because the price of a certain asset is significantly on the up, it does not necessarily indicate the formation of a bubble. It could be that a certain industry is genuinely performing excellently and so the market reflects that. The question here is, as asset prices increase, how high is too high?
There is not really an answer to this question, but some attempts have been made to find a solution. Some believe that the CAPE index (Cyclically Adjusted Price Earnings) could be used. This compares the adjusted price of an asset to its earnings (e.g. the price of a stock would be compared to the present value of the dividends earned by owning that stock). This index is then used to try and identify ‘explosive behaviour’. 
Whilst all may seem well and good, how this information is interpreted is the crux of the matter. Though it is potentially a useful metric, it must not be forgotten that there are numerous explanatory factors (e.g interest rates) which can influence market prices independently of financial bubbles. Thus, the interpretation of such a model must be made with care.
In summary of this article, it is clear that financial bubbles are not straightforward. Speculation and somewhat of a fear of missing out leads investors (both retail and commercial) to pump funding into assets that soon become overvalued. When confidence in these assets falls, so does the price, leading to the ‘popping’ of the bubble. Whilst there have been, and still are, attempts to predict the formation of market bubbles, a universal method has not been found. As a result, identifying the difference between a strong bull market and a market bubble will continue to be one of the key challenges for investors in modern finance.
Undergraduate at the University of Leeds studying Banking and Finance