Gold prices have risen 30.07% since January this year. Experts attribute many reasons to the rise in gold prices, but are divided on whether it is a bubble or not.
What is an asset bubble?
Asset bubbles happen when prices of assets rise far above their true value, mostly on account of sentiment rather than fundamentals. A sharp rise in prices is often followed by a drastic drop, which is when the bubble bursts. Bubbles can occur in capital markets, economies and industries (business sectors). Typically, they are short-lived and have little long-term impact on asset prices.
Two major stock market bubbles
Great Depression: One of the major stock market bubbles occurred just before the Great Depression in American stocks during 1920s. In the US it was a time of great economic growth and prosperity. This period was coined as “The Roaring Twenties”, which ended with a crash in stock prices and the onset of the Great Depression, which is said to have started in 1929.
Dotcom bubble: The other major stock market bubble occurred at the end of the 20th century, popularly known as the dotcom bubble. The 1990s was when Internet and e-commerce technologies emerged—stocks in this sector saw a mercurial rise in prices across the globe. It ended in March 2000 with the Nasdaq peaking in intraday trade and then closing 1.6% lower than the peak by the end of trade.
Is it possible to identify an asset bubble?
Asset price bubbles are typically classified only in hindsight after prices collapse. While there is no scientific way of identifying a bubble, especially in its initial days, over the years some broad indicators have emerged. Here is when you should be wary.
Asset prices move upwards without a break: Generally in any market, asset prices go through ups and downs even in times of growth. If asset prices are moving up for a long time without a significant break, one must be cautious.
Everyone talks about investing in an asset: Investment decisions are usually made within the confines of professional offices. When such discussions start happening at social gatherings of unrelated people, it points to widespread interest among the general public. If everyone (and not just professionals) is talking about a particular stock or asset, you need to watch out.
Everyone is making money in that asset: If everyone is making money and no one is talking about losing money, clearly prices have been moving upwards for a long time. This is a time when you know that the bubble could be close to its peak and prices could take a U-turn anytime soon.
Herd behaviour from investors accentuates asset bubbles. So if you suspect a price bubble in any asset, the rule of thumb should be not to do what everyone is doing and not follow the herd.