Rising prices are not, on their own, a sign of a bubble. Prices rise for good reasons all the time: profits grow, populations increase, new technologies create value, interest rates fall. Calling every strong market a bubble is as unhelpful as never recognising one.
So how can you tell the difference? There is no test that gives a certain answer. What analysts can do is look for a set of characteristics that have appeared, in varying combinations, across many past bubbles. The more of these characteristics are present, and the more extreme they have become, the higher the risk that a boom has turned into a bubble.
This article sets out those warning signs as a practical checklist, grouped into six areas: prices and valuation, the economic background, the story, the participants, credit, and policy and currency. It explains why each matters, how to observe it, and how to weigh the checklist as a whole. It forms part of GoCore’s series on bubbles; the stages through which bubbles typically pass are described in The anatomy of a bubble.
How to use the checklist
Not every item appears in every bubble, and some items appear in perfectly healthy markets. The checklist is a tool for judgement, not a formula. Three principles help:
- Count the signs. A market showing one or two characteristics is very different from one showing most of them.
- Judge the intensity. A modest rise in lending is not the same as lending growing at several times the pace of incomes.
- Watch the direction. A market where signs are accumulating is more concerning than one where they are fading.
The checklist can be applied to share markets, housing markets, commodity markets, particular sectors such as technology, and even to the market for a particular kind of business or product.
Group 1: Prices and valuation
Rapidly rising prices
A bubble obviously involves a period of rapidly rising prices. But a strong rise alone does not imply a bubble, because prices may be recovering from undervalued levels. A share market that doubles after a crash may simply be returning to normal.
High expectations of continuing rapid rises
More telling than the rise itself is the expectation that it will continue. When buyers base their decisions on prices continuing to rise at recent rates, rather than on the income an asset produces, the market is vulnerable. Surveys of investor or home-buyer expectations, and the language used in marketing and media, often reveal these expectations.
Overvaluation compared with history
Valuation measures compare price with something fundamental: earnings for shares, rents or incomes for housing. When these measures move well above their long-run averages, the risk of a bubble rises. For example, during the late-1990s technology boom, the price-earnings ratio of the main US share index rose to roughly double its long-run average.
Overvaluation compared with reasonable levels
Historical averages are not the only benchmark. Valuations can also be compared with what is reasonable given current interest rates, growth prospects and risk. Prices may be above history for good reasons, such as permanently lower interest rates, but there are limits to how far those reasons can stretch. The article Rising prices or a bubble? Why valuation is the best clue looks at these measures in detail.
Group 2: The economic background
Several years into an economic upswing
Bubbles typically develop after several years of solid economic growth and rising confidence. The traumas of past recessions and busts, at least in that particular market, have faded. The late-1990s US share bubble came late in a long economic expansion and after many years of rising share prices. The Asian property and share market bubbles that burst in 1997–98 followed more than a decade of rapid growth widely described as an economic miracle.
Consumer price inflation subdued
Bubbles often coincide with low and stable inflation in everyday prices. This seems reassuring, and it often leads central banks to keep interest rates low, because their main target, inflation, appears under control. But low inflation in consumer prices can coexist with rapid inflation in asset prices, and the calm in one can disguise the excess in the other.
Group 3: The story
A genuine underlying reason for higher prices
Almost every bubble has a real foundation: rising profits, strong population growth, falling interest rates, an important new technology. This is what makes bubbles hard to identify. The reason is sound; the question is whether prices have moved far beyond what it can justify.
A new element
Bubbles typically involve something new that appears to change the rules: a technology, a new economic model, a new source of demand such as immigration for housing, or a new financial product. In the 1990s it was computers, networking and an apparent acceleration in productivity growth. In the 1980s in Japan it was the belief that the Japanese model of management and manufacturing would dominate the world.
A subjective “paradigm shift”
Closely related is the belief that the old ways of valuing assets no longer apply, usually summarised as “this time is different”. A new era is said to have arrived, in which old limits are irrelevant. The article “This time is different”: the stories that inflate bubbles explores these narratives.
Group 4: The participants
New investors drawn in
When people who have never invested in a market start buying, it suggests that the pool of potential buyers is being exhausted. Rising numbers of new brokerage accounts, first-time property investors or participants in a newly fashionable asset are classic signs.
New entrepreneurs entering the area
Bubbles attract new businesses. Companies are formed to exploit the opportunity, existing businesses rename themselves to associate with it, and promoters launch new schemes. During the technology boom, companies sometimes saw their share prices jump simply by adding an internet-related term to their names.
Considerable popular and media interest
When a market becomes a constant topic of conversation, appears frequently on front pages and dominates social discussion, it has moved beyond specialists. Popular attention brings more buyers, but it also signals that few people remain who have not yet joined.
Group 5: Credit
A major rise in lending
Most significant bubbles involve a substantial rise in lending by banks or other lenders. Sometimes this reflects regulatory changes that allow lenders to lend more freely; often it involves new entrants to the market. The housing bubbles in the United Kingdom and Scandinavia in the 1980s followed the liberalisation of banking systems.
Increasing indebtedness
As lending rises, debt rises relative to income. Households and businesses take on obligations based on the assumption that asset prices, and the incomes that support them, will remain high.
New lenders or new lending policies
New lenders, new loan products and relaxed lending standards are especially telling. Loans with very small deposits, interest-only repayments, minimal checking of income or long periods of low introductory rates allow buyers to pay prices that their incomes could not otherwise support.
A falling household savings rate
When people feel richer because their assets have risen in value, they often save less of their income, or borrow against their assets to spend. A falling savings rate during a boom can indicate that spending is being supported by asset prices rather than income. The article Wealth effects explains this mechanism.
Group 6: Policy and currency
Relaxed monetary policy
Behind many bubbles lies a relaxed monetary policy: low interest rates, rapid money growth or, more importantly, rapid growth in credit. Unusually low real interest rates, meaning interest rates after allowing for inflation, are a particular warning sign, because they make borrowing to buy assets especially attractive.
A strong exchange rate
Most bubbles are accompanied by a strong currency or, where the currency is fixed, an inflow of money from abroad. Money flows into the country, attracted by the booming asset or the strong economy. The strong currency in turn tends to produce trade and current-account deficits. The article Bubbles, strong currencies and capital flows explains the connection.
The checklist in summary
| Area | Warning sign |
|---|---|
| Prices and valuation | Rapidly rising prices |
| Expectations of continued rapid rises | |
| Valuations well above historical averages | |
| Valuations well above reasonable levels | |
| Economic background | Several years into an economic upswing |
| Subdued consumer price inflation | |
| The story | A genuine reason for higher prices |
| A new element: technology, model or source of demand | |
| Belief in a “paradigm shift” | |
| Participants | New investors drawn in |
| New entrepreneurs entering | |
| Intense popular and media interest | |
| Credit | Major rise in lending |
| Rising indebtedness | |
| New lenders or looser lending policies | |
| Falling household savings rate | |
| Policy and currency | Relaxed monetary policy and low real interest rates |
| Strong exchange rate or capital inflows |
Weighing the evidence
Deciding whether a particular boom is a bubble remains a matter of judgement, based on how many characteristics are present and how extreme they have become.
A simple approach is to score each item from zero (absent) to two (present and extreme), and to watch both the total and its direction over time. The score will not tell you when a bubble will burst. It can, however, show whether risk is rising or falling, and prompt a more careful look when many signs appear at once.
The difficulty of timing
The technology bubble of the late 1990s shows both the usefulness and the limits of the checklist. By late 1999 and early 2000, almost every sign was present and extreme, and it should have been clear that this was a bubble. But by then the bubble was close to its peak. The technology-heavy NASDAQ index rose from around 2,800 in October 1999 to just over 5,000 in March 2000, then fell back below 2,800 by December 2000, eventually losing close to four-fifths of its peak value by late 2002.
Ideally, a high degree of risk would have been recognised much earlier, around 1998, when several signs were already strong. Yet anyone who acted on that recognition would have watched prices keep rising for well over a year. The checklist identifies risk; it does not identify timing. The article Why bubble warnings come too early explores this tension.
Applying the checklist beyond financial markets
The same signs can appear in the market for particular kinds of businesses, products or skills.
- Business acquisitions: prices for businesses in a fashionable sector can rise well above what their earnings justify, with new buyers and generous financing.
- Commercial property: rents and prices in a booming area can rise on the back of one major project or industry.
- Equipment and inputs: prices for machinery, materials or specialist labour can spike during a boom in the industries that use them.
- Technology categories: a new category can attract floods of start-ups, investment and media attention, with valuations based on expectations rather than revenue.
For business owners, recognising these signs can prevent paying boom prices for assets, building capacity for demand that will not last, or depending on customers whose spending rests on inflated asset values.
A worked illustration
This is an illustration, not a description of any real market.
A regional city has experienced strong growth for eight years, driven by a new mining development nearby. A small business owner considers buying a commercial building to expand. Working through the checklist:
- Prices: commercial property prices in the city have risen 60% in four years.
- Expectations: local agents talk confidently about further rises.
- Valuation: rental yields have fallen from 8% to 5%, well below the long-run level for the area.
- Economic background: the local economy has grown strongly for eight years.
- The story: the mine is real, and new projects are planned, but all depend on commodity prices.
- Participants: investors from other cities are buying, and several new developers have arrived.
- Credit: lenders are offering high loan-to-value ratios on commercial property.
Most of the signs are present. The owner decides to lease a larger premises on a flexible term instead of buying, keeping capital and options open. Two years later, commodity prices fall, a planned project is cancelled and commercial property prices in the city drop. The business, without a large mortgage on a falling asset, adjusts more easily.
Common mistakes
Treating one sign as proof. Rising prices alone do not make a bubble.
Dismissing the signs because the story is real. Genuine opportunities can still be badly overpriced.
Assuming the checklist predicts timing. It shows risk, not the date of a turn.
Applying it only to financial markets. Local property, business sales and input prices can show the same signs.
Ignoring the direction of change. Accumulating signs matter more than a static snapshot.
Questions to ask
- How many of the warning signs are present, and how extreme are they?
- Are valuations far above historical and reasonable levels?
- Is credit expanding rapidly, with new lenders or looser standards?
- Are new, inexperienced participants arriving in large numbers?
- For your own business: are you paying boom prices, or relying on boom demand?
Bringing it together
No single signal proves a bubble. But bubbles tend to share a family resemblance: rapidly rising prices backed by confident expectations, valuations far above history, a long economic upswing, a compelling new story, waves of new participants, rapid credit growth, relaxed monetary policy and a strong currency.
Using the checklist means counting the signs, judging their intensity and watching their direction. It will not tell you when a boom will end, but it can tell you when the risk has become high enough to change your decisions.
Sources: an introductory chapter on asset bubbles written in the mid-2000s, which credits an earlier HSBC research note, together with widely documented market history. Examples are illustrations unless stated otherwise. This article is general information, not financial or investment advice.
