The Price, Demand, and Expectations Feedback Loop

In my view, the essential characteristic of a bubble asset lies in the strong positive correlation among three factors:

1. Price
2. Demand
3. Expectations (often referred to as hype)

During a bubble, fundamental values are often disregarded as prices rise significantly beyond what immediate cash flows can support. This situation typically leads to the involvement of marginal buyers who are both leveraged and speculative. Consequently, price movements become the primary catalyst for demand. When prices increase, greed and heightened expectations drive demand further up, resulting in even higher prices. Conversely, when prices decline, fear takes over, leading to a drop in demand. Thus, bubbles create a self-reinforcing loop of price, demand, and expectations.

Bubbles Distort Traditional Supply and Demand Dynamics

This phenomenon is a pivotal distinction between bubble assets and standard commodities or bonds, which have more predictable future cash flows. For instance, in the case of a typical good like beef, an increase in price leads to a reduction in demand (as consumers seek cheaper alternatives) and an increase in supply (as sellers aim to capitalize on higher prices). This tendency usually facilitates a return to equilibrium.

In contrast, bubble assets lack this inherent ability to self-correct. When prices rise, demand for these assets often escalates, allowing prices to surge for a period. Even an uptick in supply can be misinterpreted by overly optimistic investors. Typically, excessive supply is what triggers the bubble's collapse. However, before the inevitable downturn, rising supply is frequently perceived as a positive sign, indicating broader acceptance of the asset.

Defining a Bubble

Now, let’s formulate a definition of a bubble. To me, a bubble must satisfy the following criteria:

1. Unclear Future Potential and Earnings: This ambiguity allows for a vast range of possible outcomes, making it difficult to challenge the most optimistic views.
2. Expectations of Exponential Growth: In this climate of uncertainty, hype propels valuations well beyond what can be justified by short-term profits, with most value hinging on overly optimistic projections for the distant future.
3. Strong Correlation Between Price, Demand, and Expectations: As previously mentioned, when prices rise, demand and hype similarly increase, reinforcing this feedback loop.
4. Perception of Increased Supply as Positive: Typically, more supply leads to greater competition and reduced returns. A red flag for bubble conditions is when investors overlook basic economic principles and view rising supply positively, as seen in the cryptocurrency market where numerous alt-coins were initially viewed as indicators of industry growth, despite many being of little value.
5. Minimal Barriers to Increasing Supply: There must be a feasible way to increase supply as prices escalate. Otherwise, demand (assuming it doesn't plummet) will consistently outstrip supply, justifying soaring prices. This point complicates my assertion regarding housing being in a bubble, as the supply is relatively static due to lengthy construction times and local regulations.

These are the criteria I believe must be met for something to be categorized as a bubble. I hope this analysis proves useful!

Section 2.1: The Role of Investor Sentiment

Market bubbles are heavily influenced by investor sentiment. When optimism prevails, even the slightest price increase can trigger a buying frenzy. Conversely, during downturns, fear can cause panic selling.

The second video, Are Market Bubbles a Function of Psychology?, discusses how psychological factors shape market dynamics, helping to explain the behavior of investors in bubble scenarios.

By comprehending these psychological elements, we can better navigate the complexities of market bubbles.