After all, isn’t pretty much everything just worth whatever people are willing to pay for it?
In: Economics
An economic bubble is characterized by an increase a significant increase in price (possibly over a long period of time) that eventually reaches a point where there is a sudden collapse (which can be triggered by many things) and the price plummets.
One theory is that bubbles happens is when too many people overvalue the intrinsic value of something to the extend you reach an unstable situation.
For example, in the housing crisis in the mid 2000’s, a number of factors drove up the demand of houses: lower interest rates easy-to-get mortgages. This increase in demand drove up house prices. Eventually when people couldn’t pay their mortgages, the banks had to foreclose. Suddenly supply drives through the roof and demand sinks, and the bubble collapses.
The problem is, you really can’t know you’re in a bubble when you’re in one. It’s more of a description of an economic phenomenon after it happens. That doesn’t stop people from trying to predict whether we are in one, based on their own theories about an asset’s intrinsic value and what they *think* it is worth.
Overvalued means the value comes from “artificial” demand. People buying Not because they want the product, but because they speculate the price will increase further to sell for a profit.
If something is a bubble or not If often hard to see before it bursts. Some things hype because there really is a chance that the value of the good will have that price without speculative buyers. (This is especially true for innovative stocks, like startups with a technology that might go through the roof). A bubble is defined as something that is priced in a way that it can’t keep that price up without new speculative buyers.
A key thing in any market-based valuation is that the listed price is whatever the *last* person paid for it.
Suppose there’s a stock with 1 million shares. Yesterday, someone paid $100 to buy it. A simple (and popular) calculation of the total value of those 1 million shares – its “market cap” – is $100 million. Should you trade $100 million for ownership of all those shares? Probably not.
That market cap calculation is based on the assumption that because one guy bought the stock at $100, you could find 1 million other buyers who all agree it’s worth that much. This assumption isn’t so bad if the price of the stock is stable and based on fundamental things like the profitability of the company that issued it. However, it really starts to break down in speculative environments where the main determinants of valuation are how much others expect the stock’s price to go up and how much they’re willing to risk on that bet.
> After all, isn’t pretty much everything just worth whatever people are willing to pay for it?
Yes. A lot of economists will tell you that there are no such things as bubbles. For example Scott Sumner: https://www.themoneyillusion.com/whatever-floats-your-boat/
While in essence things are worth what people are willing to pay for them, some of the value is more tangible and “real”, based on a lot of factors like the utility, elasticity, solidity and versatility .
For example, you have rocks that can be sold as a pet for $10, as paperweights for $5 or as building materials for $0.50. Now, let’s say you buy stock from a quarry that’s been supplying pet rocks. They have their inventory valued at $6/rock, so everyone thinks there’s a $4 profit to be made per rock, but what would happen if the demand for pet rocks vanished?
Housing is another clear example. Interests rates are very low right now, which means people are able to borrow higher amounts. Sellers know this, so they increase the price to balance supply and demand. People see the increase in prices and think they can make a profit by flipping houses and by doing so, they increase demand which in turn increases the prices even higher. Suddenly a house that was worth $100,000 is now being sold for $300,000. But what is the real value if the FED raises interest rates? They are one uncontrollable decision away from going back to “normal”.
Economists consider as many factors as they want and create a model that is meant to assign probability of different scenarios. Of course, they are often wrong. Tesla can be both described as grossly inflated because it would take decades for the company to realize it’s value with the rate of profits it has, or it can be considered a solid investment because they spearhead an industry that is growing incessantly.
There are typical ways items are valued, say by determining actual utility, income generation, cost of creation, cost of comparable items/investments.
typically a bubble is when the prices paid are a result of people thinking they can sell for more tomorrow, than based on more fundamental financial analysis.
For example, investment real estate may be looked at based on the cap rate, which is rent return based on cost of property. If historic cap rates are 10% and they fall to 2%, that’s an indicator that prices are too high relative to the income made. If mature stocks typically trade with a P/E ratio of 15 and a stock is trading with a P/E of 150 and it isn’t a high growth start-up, that could be a bubble.
A good recent example is GameStop stock… the company is likely trending downward longterm because malls are fading, retail in general is fading, physical game media is fading. They’d have to make some pretty fundamental changes to remain relevent and profitable. Maybe there is some hope to improve from where the company is now… but it was a $4 stock not that long ago. Can they double their business and grow to an $8 stock? Even that seems like a long shot! So why did it jump to $20, and $40 and even over $300? Sure there were the shorts covering and all, but lots of people jumped in to buy GME because they thought it could keep skyrocketing. They didn’t care that fundamentals suggested it was a $4 stock if they thought they could buy at $40 and sell for $200.
Latest Answers