What Do Terms 'Bubble,' 'Crash' Really Mean?
Saturday, October 11, 2008
We toss around the terms "bubble" and "crash" fairly easily these days, but what do they mean? Are they just vague words used to describe flush or tough times, or do they have actual meanings? Turns out, it's the latter.
Q What is a bubble?
ARemember the phrase "irrational exuberance" popularized by former Fed chairman Alan Greenspan to describe the stock boom of the 1990s? A bubble is like a gold rush -- lots of people trying to make a quick buck by betting that something is going to be valuable. A bubble happens when demand for something, say, a Dutch tulip bulb in 1636 or a tech stock in the 1990s, far exceeds the supply. That inflates the price for the product much higher than it should be compared with what the product is actually worth.
How did a little dial-up Internet company -- AOL -- buy a huge movie, TV and magazine company -- Time Warner -- in 2000? Because the tech bubble had pushed AOL stock to nearly $100 per share, probably 10 times what it should have been trading at.
Here's how we knew we were in a housing bubble: Historically, houses sell for about four times a person's disposable income. But in 2006, just before the housing bubble burst, houses were selling for 5.2 times disposable income, said Tim Hanson, senior analyst at Alexandria's Motley Fool. Now, he said, it's back down to about 4.5 percent.
What is a crash?
It's when the air comes out of a bubble, when shareholders sell their stock, or outside influence drains value. Sometimes it leaks, sometimes it pops. When we hear the word "crash," we think of a sudden event, like a car crash. Sometimes -- such as on Black Monday, Oct. 19, 1987 -- that's how the stock market crashes. But sometimes the air leaks out of a bubble more slowly and it takes longer to recognize a crash. Generally, a crash is defined as a rapid 20 percent drop in the value of anything. "Rapid" can mean a few or several days, but is used to distinguish between a crash and a soft landing, or slow descent in the economy over a longer period of time. Everyone remembers October 1929. But here are some other big crashes you might not: 1973, 1937, and the panics of 1893 and 1907.
So, are we in a crash now?
We may be in several crashes right now -- stocks, credit, housing, you name it. The key is that everything doesn't necessarily crash at the same time or at the same rate.
"The crisis was caused by the largest leveraged asset bubble and credit bubble in the history of humanity," writes Nouriel Roubini, professor of economics at the New York University Stern School of Business, "where excessive leveraging and bubbles were not limited to housing in the U.S. but also to housing in many other countries and excessive borrowing by financial institutions and some segments of the corporate sector and of the public sector in many and different economies."
Then he goes on to list our bubbles: "A housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge funds bubble are all now bursting at once in the biggest real sector and financial sector deleveraging since the Great Depression."