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Stock Market Bubble: What It Is & How It Happens

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What Is a Stock Market Bubble?

A stock market bubble generally refers to a situation where the price of stocks far exceed their intrinsic or fundamental value. Bubbles are typically driven by investors overcome with optimism about a rising stock market (or market sector) and the fear of missing out (FOMO).

The bubble inflates until stock prices reach a level beyond economic or fundamental rationality, and/or when the new investment flows that would be necessary from investors and speculators to drive further price increases actually dries up. When no more investors can be found to invest at that price level, the bubble usually begins to collapse. In highly speculative markets, the collapse can occur quickly, making it extremely difficult for investors to get out of the market before suffering significant losses.

What Happens When a Stock Market Bubble Bursts?

The sell-off from a bursting investment bubble can have severe and widespread consequences. The extent of damage depends on whether the bubble centers around a smaller subset of stocks, in which the damage could be minimal, or a large sector such as technology stocks which could trigger a market-wide contagion. In addition to the stock market losing a significant portion of its value, a bubble that bursts can lead to severe economic shocks, such as the recessions that occurred in the aftermath of the dot-com bubble in 2000 and the housing bubble in 2008.

Key Takeaway: A stock market bubble inflates until stock prices reach a level beyond economic or fundamental rationality and/or when the new investment flows that would be necessary from investors and speculators to drive further price increases actually dries up.

Stages of a Stock Market Bubble

Investors often are not aware when they are operating in a bubble. It’s typically not until the bubble bursts that it becomes obvious. However, there are tell-tale signs that a bubble may be forming, as described by economist Hyman P. Minsky in his book Stabilizing an Unstable Economy in 1986. He describes the five stages of a credit cycle, which outline the basic pattern of a bubble.

1. Displacement

A displacement happens when investors become fixated on a new development in the market or economy that changes their expectations, such as when dot-com companies emerged in the late 1990s.

2. Boom

This is the phase following a displacement when it becomes a reality and investors start bidding up stock prices. It begins slowly and gains momentum as media build up the narrative, attracting more participants into the market.

3. Euphoria

At this point, it turns into a “get rich quick” scheme, with investors throwing caution to the wind. As stock prices skyrocket, it appears to investors that it will last forever, ignoring that valuations are reaching extreme levels. No one wants to be left behind.

4. Profit-Taking

Eventually, the “smart money”, insiders and investment pros, see signs that the market is at a tipping point and that the bubble is at risk of bursting. These players are typically the first to get out and take profits. Insider selling then accelerates, triggering panic selling.

5. Panic

When a bubble finally bursts, it can create a contagion that cascades quickly over the entire stock market, taking unsuspecting investors with it. Soon the supply drowns out demand causing stock prices to overshoot to the downside just as euphoria caused them to overshoot to the upside.

Key Takeaway: Though stock market bubbles are difficult to predict or recognize as they are occurring, they typically have five distinct stages that characterize their development and eventual collapse.

Types of Bubbles

Conceivably, any asset that can cause a speculative frenzy could be caught up in a bubble. In the 17th century, it was Tulipmania, around tulip bulbs, whose prices soared to mystifying levels before the bubble burst. This ended up threatening the economies of Holland and surrounding countries before the Dutch government intervened. More recently, the U.S. housing bubble led to the global financial crisis in 2008 and 2009. Some observers fear that the meteoric rise in cryptocurrency prices also has most of the earmarks of a bubble.

Generally, the types of asset bubbles can be categorized as follows:

1. Stock Market Bubbles

Bubbles can occur in the overall stock market, or stocks in a particular market sector such as technology, or sometimes just individual securities. Wherever stock prices rise quickly and exceed the underlying companies’ fundamental value, this can create a bubble.

2. Asset Bubbles

Bubbles can occur among asset groups outside of stocks, such as real estate, currencies, cryptocurrencies. The U.S. housing bubble that preceded the Global Financial Crisis is the most recent example of an asset bubble. Low interest rates and lending standards fueled a housing boom encouraging millions of people to borrow beyond their means to buy homes they couldn’t afford.

3. Credit Bubbles

A sudden surge in consumer or business debt, debt instruments, and other forms of credit can create a credit bubble. A credit bubble could potentially occur due to consumers’ heavy reliance on credit card and/or student loan debt or other type of credit.

4. Commodity Bubbles

Commodities, such as oil, gold, silver, nickel, and tin, among others, are often the target of speculators who can quickly drive up prices before taking profits.

5. Economic Bubbles

The effects of stock market and asset bubbles can sometimes spill over into the general economy, initially causing a surge in economic growth that threatens to overheat the economy. The bursting of the bubble can lead to a recession.

Key Takeaway: Bubbles may occur among any asset group that can be affected by speculation or unrealistic expectations of their future value.

History of Stock Market Bubbles

History presents clear examples of stock bubbles dating back to the early 18th century. Three of more devastating stock market bubbles have taken place in the last one hundred years.

1929 Stock Market Bubble

There is still debate over the cause of the crash of 1929 and whether it was the result of an investment bubble that grew over time or as the result of a four-day panic that started on Black Thursday, October 24, 1929. The country was experiencing an unprecedented period of prosperity and growth. Technology was transforming the country, and industrial production output was doubling every four years. The stock market benefited from the expanding economy, quadrupling from 1926 to 1929. Money was loose and cheap, which fueled much of the rise.

Much of the history written on the Crash focuses on the rampant speculation in the market at the time. Yet, historians have revised their views on the market, questioning whether share prices had indeed exceeded the intrinsic values at the time. Some have shown that most stocks were fairly valued in relation to company earnings and dividends. Instead, the focus shifted to the four days of panic that saw share volume increase more than tenfold. The inability of the system to handle the volume blinded investors from actual trade results, which triggered an even bigger panic that snowballed over the four days.

Source: eh.net

1991 Japan’s Stock Market & Real Estate Bubble

To rescue the Japanese economy from a deep recession in 1986, the government countered with a monetary and fiscal stimulus program. The measures were quick and effective, resulting in a tripling of stock and urban land prices between 1985 and 1989. Speculation was the primary driver of the frantic activity in the stock market and real estate, leading to excessive valuations in both.

When the bubble burst in 1991, it ushered in a decade of price deflation and stagnant economic growth, known as the “lost decade”.

2000 Dot-com Bubble

The dot-com bubble in the late 1990s resulted from a rapid surge in the NASDAQ stock market driven by speculative investments in internet companies. Through a massive number of initial public offerings, investors and speculators followed venture capital money into internet startups that in some cases had yet to earn any revenues, much less generate profits. Their stock prices would triple or quadruple within a day, creating a feeding frenzy for investors.

The NASDAQ peaked on March 10, 2000, after a nearly doubling over the prior year. When investors eventually got nervous over unjustifiably high valuations, it triggered massive selling in all tech stocks. Many of the new dot-com companies that had reached valuations of hundreds of millions of dollars were reduced to nothing within months. By the end of 2001, most publicly traded dot-com startups folded, and trillions of dollars of investment capital vanished.

Bottom Line

A stock market bubble is the result of a sudden surge in stock prices over their intrinsic value. When investors decide stock prices far exceed their fundamental value and begin to sell their shares, it triggers a massive sell-off, bursting the bubble and trapping investors who can’t sell their shares fast enough.

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