Spotting Asset Bubbles

Spotting Asset Bubbles

Asset bubbles are formed when a service, product or company becomes massively over-valued only to crash, taking with it most of its investors’ money.  There are many examples of asset bubbles in history – the Dutch tulip bulb mania and the South Sea bubble are two of the most famous historical examples.  In the tulip mania bubble of 1636-37, the price of tulip bulbs became astronomically high – as people speculated that the rising prices would keep rising yet further.  At its peak a single tulip bulb was changing hands for around 10 times the annual wage of a skilled artisan, before crashing to become virtually worthless.

More recent bubble include the Dotcom crash of the early 2000s – where investors piled in trying to spot in what ways the internet would revolutionise businesses.  Huge numbers of internet companies tried to ride this wave by going public with share offerings.  This led to massive overvaluation and a crash when investors realised that many of these companies were worthless.  Pets.com is often given as an example of this exuberance – its stock collapsed from $11 to $0.19 in just 6 months, taking with it $300 million of venture capital.

Therefore spotting the next bubble is something which economists take very seriously.  You want to spot the next bubble, but equally not to miss out on the next big thing – a difficult balancing act!  The graph at the top of the page is given as a classic bubble.  It contains all the key phases – an initial slow take-off, a steady increase as institutional investors like banks and hedge funds get involved, an exponential growth phase as the public get involved, followed by a crash and a return to its long term mean value.

Comparing the Bitcoin graph to an asset bubble

The above graph is charting the last year of Bitcoin growth.  We can see several similarities – so let’s try and plot this on the same axis as the model.  The orange dots represent data points for the initial model – and then I’ve fitted the Bitcoin graph over the top:

It’s not a bad fit – if this was going to follow the asset bubble model then it would be about to crash rapidly before returning to the long term mean of around $4000.  Whether that happens or it continues to rise, you can guarantee that there will be thousands of economists and stock market analysts around the world doing this sort of analysis (albeit somewhat more sophisticated!) to decide whether Bitcoin really will become the future of money – or yet another example of an asset bubble to be studied in economics textbooks of the future.