- [Narrator] A bubble in a financial sense
is something you are probably familiar with.
- It was the worst day on Wall Street
since the crash of 1987.
- [Narrator] Two of history's biggest bubbles,
one in dot com stocks, the other in the US housing market,
both burst in the last 30 years
ushering in periods of recession.
- As you are aware,
the US economy is undergoing a severe contraction.
- [Narrator] Smaller bubbles,
like one in Dogecoin have popped even more recently.
And over the past year, many analysts were warning
that this market was flashing a red alert, but not so fast.
- It's incredibly hard to predict
or call a financial market's bubble when you're in it.
- [Narrator] So rather than get out the crystal ball,
let's turn back the clock
to look at what bubbles are, how they burst
and why history keeps repeating itself.
A bubble is a market condition
created by a rapid surge in the price of an asset
to levels that far exceed that asset's fundamental value.
Here, it's helpful to think of an asset bubble,
more like a balloon
where the air inside represents investment
and the size is its value.
The balloon has an ideal size, it's fundamental value
but it can inflate and deflate
as air is put in or pulled out
and investors have ways to track these movements.
- So a lot of investors look at a metric
like the price to earnings ratio of the stock,
which basically measures how much am I paying up
for this company's earnings?
And is this company worth what I think it is
- [Narrator] Going back in time to the 1600s,
provides one of the earliest examples of an asset ballooning
at the top time, tulip bulbs
especially the ones producing the rarest flowers
were so in demand
that they were being purchased on contract
before they were even grown.
According to 19th century writer, Charles McKay
a single rare bulb could at one point
be exchanged for dozens of items combined
including two bundles of wheat, four oxen and 12 sheep.
Still people didn't spot the bubble.
- One feature of a market bubble
is that it tends to kind of pull in so many people
and that makes it incredibly hard to spot it
while you're living it
because it might make sense at the time
- 5,000 shares at 26.
- That writer McKay even missed a bubble in his time
when the prices of British railway stocks
did this in the 1840s.
The only real way to know if an asset is ballooning
is to wait for it to pop or rather deflate rapidly
as seen in 2021 with Gamestop.
- Well the Gamestop trading craze seems to be slowing down.
Shares dropped about 17% yesterday
as trading volume dried up.
- [Narrator] GameStop provides an example
of how bubbles behave
and it roughly follows a five stage process
economist Hyman Minsky developed in the 1960s
to explain credit cycles.
The first stage Displacement,
when investors start to notice a new pattern
emerging in the market.
In the case of GameStop,
the trend is first seen in online forums
where people start sharing their big wins
- Cheers everybody! (chuckles)
- [Narrator] It drew in people
who may not have traded before
who were trading stocks on online brokerages
for the first time
- [Narrator] That's stage two, the Boom,
when prices start rising
as excitement drives new investors into the asset.
That's quickly followed by stage three Euphoria,
when prices take off
- There was a sense that, "Hey, this thing can only go up,"
even though, you know, the company had not changed at all
within the span of a few days, or a few weeks, even.
- [Narrator] Which leads into stage four, Profit Taking,
when some investors begin selling their positions
- All of a sudden it's not rising anymore
and this momentum trade that you got into
is no longer working.
- And lastly Panic, when prices drop rapidly
and many investors look to get out at any price
often for far less than they bought in.
- Some investors I spoke to
in the meme stocks, in particular
were saying that led me to ditch this whole meme stock trade
and taught me how dangerous it really was.
- [Narrator] So how exactly do bubbles form?
There's no single explanation,
but in 1996, Federal Reserve Chairman, Alan Greenspan
coined a term to explain it
and it's been associated with bubbles ever since.
- But how do we know when irrational exuberance
has unduly escalated asset values?
- [Narrator] Greenspan is warning that irrational exuberance
on the part of investors can fuel a bubble
and that excitement can stem from a number of factors,
a big one, the fear of missing out or FOMO.
- There are a few things more powerful
than seeing the people around you getting really rich
and that has been a key driver of market bubbles
in the past.
- [Narrator] Greenspan first spoke of irrational exuberance
in the '90s
in an attempt to slow a rally in the stock market,
but investors kept buying,
particularly in hot dotcom stocks.
- [Voice Over] I brought something for you from pets.com
- [Narrator] But it wasn't just FOMO that drove investors
to ill fated companies like pets.com.
Another factor was at play
ahead of the dotcom bubble burst, low interest rates.
- It's simple math.
You have a few different options
for where to park your money for returns
and the safest thing possible government bonds, treasuries
is yielding basically nothing.
So what do you do?
You end up going into riskier corners of the market.
- [Narrator] At the time, some of the dotcom companies
had no earnings to speak of
but investors saw them as innovative
and we're willing to bet on future returns.
- So bubbles can also form
during times of technological or financial innovation,
whether it was railroads centuries ago,
the internet around the 2000s
or collateralized debt obligations
ahead of the great recession
- [Narrator] In all of these cases,
the bad bets ultimately shook the entire US economy.
Both the dotcom and the US housing bubbles grew so large,
that following their bursts,
the US entered periods of recession.
- So even if you weren't investing in internet stocks
or mortgage backed securities,
you could still be hit by the fallout from that bubble
because unemployment spiked after those bubbles burst.
- [Narrator] And interestingly in times of recession
like the one tied to the COVID-19 pandemic
the Federal Reserve often moves to decrease rates,
potentially creating conditions
that again drive investors to riskier assets.
While some believe this makes bubbles inevitable.
It's still incredibly hard to call
if, and when you're in one.