Asset Price Bubble: Definition & Model

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

This lesson will look at the formation of asset bubbles, what they are, why they form and if certain factors can predict their occurrence. The first recorded bubble, tulip mania in 16th-century Holland and the U.S. housing bubble will be used to illustrate.

Back in the 1600s, there was a botanist in Holland named Hans. He was always looking for new and interesting plant life to study, and on a trip to Constantinople he found his latest project, tulip bulbs. He planted those bulbs in his yard and was pleased to find they would grow in the northern climate. Soon his neighbors were stopping by and were commenting on the beauty of the multicolored flower. And of course they wanted to buy a bulb or two and have tulips in their yard too!

The word about tulips began to spread, and soon Hans and his neighbors were growing tulips and harvesting the bulbs as fast as they could. Wealthy people were stopping by and offering crazy prices for the prized bulbs which had become a coveted luxury item. The price for tulip bulbs was skyrocketing. Soon speculators came into the picture; they were people who didn't even want tulips or bulbs but did want to get rich buying and selling tulip contracts on a futures market! Things had gotten completely out of control at this point; they called it tulip mania. The price for one bulb was more than an average craftsman could make in many years.

Tulip Mania!

Tulips were a very prized commodity in 16th century Holland.

Tulip mania in 17th-century Holland was the first known asset bubble. Asset price bubbles occur when the market price of an asset is greater than its fundamental value, which is saying the asset is selling for more than it is actually worth. Asset bubbles are just like the bubbles you made when you were younger; it is fun to watch them grow, but they always burst! Asset prices, it seems, will always return to something close to their fundamental values.

And so one day back in Holland, a wealthy trader agreed to buy a very large number of bulbs for a very high price from a wealthy farmer. At the last minute, the buyer found some good sense and decided to back out of the deal. The word about this spread. People knew that bulb prices were not sustainable and wondered what the wealthy trader knew that they didn't. Soon everyone who owned bulbs or contracts for them wanted to sell, and with no buyers to be found, the price of bulbs nosedived! By the time all of the damage was done, fortunes were lost and Holland's economy nearly collapsed

Why do Asset Price Bubbles Form?

Asset bubbles like tulip mania form for many reasons. The interesting part is they have more to do with human behavior and psychology than economics! Some are just overreactions to events, like the feds 'easy money' policy in the late '90s fueling the internet bubble. Behavioral reasons for bubbles include the greater fool theory which asserts that people will pay outrageous prices for assets as long as they believe there is a greater fool out there who will pay even more. This one applies to house flippers.

Another one widely known in securities markets is the herd theory. Once traders get the idea that other traders are moving into a particular investment or stock, they will likely follow the herd and buy the stock too! In the 1930s, Economist John Maynard Keynes spoke of animal spirits being present in securities markets. He asserted that as investing in stocks spread to the middle class in the '20s, the boom in stock prices that followed was based more on ''spontaneous optimism rather than mathematical expectation.'' That particular bubble collapsed into the Great Depression!

What is an Asset Really Worth?

Analysts are always looking for ways to find answers for this. There are a number of ways to determine a fundamental value for financial assets. The most popular one is the discounted cash flow model. Cash flows from the asset in future years are forecast and then discounted to their present value at an appropriate interest rate. This calculation results in a fundamental value for the security which can be compared to its market price to determine whether it is over or under valued.

A popular way to develop fundamental values for housing was developed by Robert Schiller. He approximates the basic value of housing in America based on two things. One is how much it costs to build homes at current prices. The other is the amount a home can be rented out for. These are then inserted into mathematical formulas to calculate an index number. When you compare those values to the price of housing in the real estate market, it is easy to see if there is a bubble.

There is a growing gap between market value and construction cost in the early to mid

There was definitely a bubble in housing prices in the early to mid-'00s.

Economic Models

Modern economists are interested in why assets become overpriced and the formation of bubbles. They take a more empirical view, though. Studies identify the presence of certain factors that will increase the likelihood of bubbles forming in a market. They include:

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