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What is a bubble?

| Posted by: Paul Donovan | Tags: Paul Donovan Weekly

  • In financial terms, the word "bubble" is like the word "recession"; often used, but lacking a proper definition. A bubble is more than a market trading above fundamental value. Fundamental models are rarely very precise. Prices above fundamental value are a necessary, not a sufficient condition for a bubble.
  • Bubbles nearly always occur in new products. Change creates uncertainty about future values. Novelty allows the dreaded cry "this time it's different" to justify defiance of fundamental values. It never is that different, of course.
  • A bubble needs a delay in the realization of real world profits. If it is quickly apparent that the new product will not generate fabulous returns, the bubble will never inflate. If the returns are promised for a distant date, there is time for a bubble to build.
  • Perhaps the defining characteristic is that bubbles burst. Are government bond markets bubbles? Bond prices are manipulated above fundamental value. However, regulators can manipulate for a very long time. No bursting argues that "bubble" is not the right term for bonds. Are cryptocurrencies a bubble? They appear to be. They meet three of the four bubble criteria. Only a bursting is required to complete the definition.