Understanding market bubbles

Abstract

Can bubbles be predicted? This has been one of the most interesting and intriguing questions. Generations of man-kind have pondered over this, but no one knows the answer till now. Many economists argue that it is not possible to identify a bubble before it busts. Other economists claim that bubbles are identifiable. While the first group believes that markets are efficient, hence any bubble can just be temporary; the second group believes that there are limits to investors' ability to take advantage of mispricing in financial markets1 . Theoretically definition of bubble is when prices of asset greatly exceed intrinsic price. The problem is that for many assets this intrinsic price is not easy to determine. In simplest terms, a bubble is an overheated market in which there are too many buyers who are too keen to buy. As a result prices rise way too fast, and this situation becomes unsustainable. This is a common pattern in any bubble that markets periodically undergo extraordinary price surges followed by exceptionally sharp declines, all accompanied by massive emotional turmoil2 . There have been many reasons suggested for occurrence of bubble ranging from excess of credit due to excessive monetary expansion to psychological aberrations of investors (extrapolating from past or herd behaviour when market moves). The huge economic and emotional loss associated with post-bubble crash leads us to study this topic in greater detail. First we seek to examine the reasons for the formation of market bubbles, the characteristics that define a market bubble, the behavioural finance aspects of market bubbles and the macro-economic policies which may lead to market bubbles. After that we aim to model market bubbles and apply a new analytical approach to see whether bubbles can be predicted. Signs of overheating can always be observed and people working in industry to claim that they couldn’t see it coming seems incredulous. We study the dot com bubble of ‘99, recent housing bubble in US and some commodities bubbles of 2000’s in greater detail. We apply our approach to all these bubbles to develop a model for predicting bubble and then apply this model to the big question of today’s world – Is gold the next bubble?3 While gold has risen astronomically over last few years mimicking IT and housing bubble, people still feel it is far from bubble. For one, for large number of years prior to current rise gold prices have remained stationary. We hence conclude our work by applying our model to Gold and predicting whether it is actually in a bubble or not.