Market Bubbles and Crashes
Financial markets are typically expected to move in the same direction as the economy. But, after the COVID-19 pandemic, the two seemed to diverge, raising concerns about broader stability.
Is a market bubble about to burst?
A whitepaper, from the CPA-Ivey Centre for Accounting and the Public Interest (now The CPA Ontario Centre for Accounting and the Public Interest), examines why bubbles are so persistent and yet seem so surprising and irrational. The authors explain the anatomy of a bubble and offer insights on how accountants can help prevent or curb market bubbles.
A centuries-old problem
Bubbles occur when investors trade on the basis of the market value of an asset, rather than on the business value it creates. Believing that someone, somewhere will always pay more for the asset in future, professional and amateur traders are tempted to invest, creating upwardly spiraling prices. Cheap credit only serves to exacerbate the bubble.
Although accountants may not be directly responsible for bubbles, they can contribute to their development. The complexities of accounting can cause fluctuating asset valuations, encouraging investors to believe prices will rise. Additionally, when assets are valued at market rates in company accounts, their fundamentals can appear stronger than they are, which again feeds investor frenzy.
Highlights
Bubbles have consistent themes
- The assets underlying the bubble were bought and sold many times before being used
- Ready availability of investment capital adds to the problem
- Many untrained investors are drawn into the bubble, increasing speculation
Investor behavior is hard to predict
- Investors tend to overestimate what others will pay for an asset
- Investments can be mispriced due to an asset’s market price deviating from its fundamental value
- By relying on market trends to value assets, investors continually elevate the price, creating a bubble
What can accountants do to help?
Our study concludes that historical cost accounting – as opposed to market values – can reduce the potential and subsequent impact of bubbles and crashes. Accountants should provide better accounting information reflecting an asset’s true, fundamental value, and remain cautious about market-based estimates of asset value, helping clients to recognize the warning signs of impending boom-and-bust cycles.