What Is a Stock Market Bubble and What Happens When It Bursts?

Investors in the stock market often talk about bubbles. Like bubbles, the stock market can rise over time. However, when the bubble pops, everything comes crashing down.

Securities markets are often cyclical, following a pattern of booms and busts. However, bubbles can result in extreme rises and drops in asset values. If you’re unlucky or have poor timing, you could lose a lot of money. That makes it important to understand what a stock market bubble is, how they work, and how to invest during a bubble.

What Is a Stock Market Bubble?

A stock market bubble occurs when participants in the stock market cause prices for stocks to rise above their fair value. This typically happens because investor confidence is higher than it should be.

Calculating a fair value for a stock is difficult, but there are many formulas investors use. For example, the price-to-earnings (P/E) ratio of the S&P 500 has averaged about 15 over the life of the index. If the P/E ratio for the index were to spike to 25 or 30, one could argue that it is being caused by a stock market bubble.

During a bubble, stock prices are inflated beyond what they should be. Eventually, they will return to a more reasonable price. Many refer to this as the bubble popping as prices drop rapidly. When the bubble pops, a stock’s price may fall to or even below its fair value as investors panic and try to limit their losses.

5 Stages of a Stock Market Bubble

There are typically five stages involved in a stock market bubble.

1. Displacement

Displacement occurs when some major change causes investors to get excited and more involved in the market.

For example, a brand new technology, such as cryptocurrencies, might cause investors to pour money into that industry. Historically low interest rates could also encourage investors to over-borrow or trade on margin to pour money into the market.

2. Boom

As investors get more excited by the displacement event and continue to invest in the financial markets, prices begin to rise. Demand for securities rises slowly at first, causing prices to exceed their fundamental value.

Over time, momentum causes demand and prices to rise even more quickly. As stocks reach higher prices, more investors buy in, fearing they will miss out on easy profits.

3. Euphoria

At the peak of the bubble, a sense of euphoria with the market or the economy causes investors to act with irrational exuberance. Asset prices reach incredibly high levels compared to their fundamental values.

Investors will commonly tout various metrics to justify the price increases the market has seen and continue to buy, hoping to capture greater profits.

4. Profit-Taking

As the bubble reaches its peak, some investors will realize that they are participating in a speculative bubble. They may begin to see warning signs that the bubble is about to burst and begin taking steps to lock in their profits.

It can be incredibly difficult to know when a bubble is about to burst, but when people begin taking profits, a downturn is likely not far away.

5. Panic

Just like a bubble can pop with just a small poke, a stock market bubble can pop based on a very small event.

Whatever the cause, once the bubble bursts, investors begin to panic and sell their assets. Because there are far more sellers than buyers, this mass sell-off causes a stock market crash as the price of stocks drops precipitously.

Depending on the cause of the stock bubble and the severity with which it pops, it can even lead to a global financial crisis.

Historical Stock Market Bubbles

Market bubbles have a long and storied history. They’re caused by inherent biases and behaviors of humanity, so you can see similarities in the bubbles that have occurred across history.

Dutch Tulip Mania

One of the first market bubbles happened in the Netherlands during the early 1600s. Although it did not lead to an economic crisis in the country, it has been a useful case study for future economists.

Tulips, along with many other plants, were first introduced to Europe in the 1500s. They were prized for their intense colors and gained popularity as a status symbol among elites, causing their prices to rise.

Hoping to profit from the popularity of the flower, many varieties were cultivated, each variety receiving an extravagant name.

Tulips take years to grow, which led to the creation of futures contracts: payments now for a promise of tulips at a set date in the future.

Tulips continued to gain popularity, causing prices to rise and traders from other countries began to enter the market. The futures market for tulips grew to the point that it was formalized and tulips became the fourth-largest export of the Netherlands.

The formalization of the futures market for tulips made it easy for anyone to begin trading in the market, causing speculation and massive price rises. By 1637, contracts would change hands five times before any tulips could be delivered.

The market crashed in 1637 due to various causes, including an outbreak of the bubonic plague.

1929 Wall Street Crash

The 1929 Wall Street crash was the most impactful stock market crash in United States history. It was preceded by the Roaring ‘20s, an era of optimism and excess and an influx of speculators into the stock market.

In March 1929, the Federal Reserve issued a warning about excess speculation in the market, causing a small drop in prices. Production of goods slowed and consumer debt rose due to easy borrowing.

Prices began to rise again in the short-term, reaching a peak in September 1929. That month in London, British investor Clarence Hatry and many associates were imprisoned for fraud, which caused the U.S. market to begin to wobble.

On October 24, 1929, also known as Black Thursday, the U.S. market lost 11% of its value at opening but regained some value due to the efforts of major bankers. The next Monday the crash worsened with a more than 12% drop. The day that followed, Black Tuesday, saw further panic and another 11% drop in stock values.

The stock market didn’t return to previous levels until 1954.

Japan’s Real Estate Bubble

Japan saw a real estate and stock market bubble between 1986 and 1991. During this period, the Bank of Japan encouraged increases in the money supply and easy access to credit. It showed an unwillingness to tighten its policies due to a recent recession caused by a rise in the yen’s value.

Real estate prices in major cities such as Tokyo rose as much as 300% between 1986 and 1991. These price increases stemmed from massive demand and heavily limited supply, as well as easy access to debt to finance real estate purchases.

Stock prices also saw significant increases. Many corporations began buying shares in their partner businesses, which reduced the number of shares trading on the market. This made price manipulation easier and caused prices to move even higher. By 1989, the Tokyo Stock Exchange’s Nikkei 225 index was 224% higher than it was in 1985.

The bubble ended with the introduction of a consumption tax, a significant increase in interest rates, and an increase in the value of the yen, making exporting more difficult. Real estate prices in major cities began to drop and the Nikkei 225 fell more than 35%.

The period between 1991 and 2011 became known as the Lost Decades because of stagnation in the Japanese economy during that period, with GDP increasing at a rate of only 0.13% per year.

Dot-Com Bubble

The Dot-Com Bubble occurred in the late 1990s. During this time, the internet was growing at a rapid pace and many businesses reached absurd valuations based solely on their plans to use the internet.

The bubble was caused in part due to low interest rates making it easy for entrepreneurs to fund startups, even without solid business plans. The novelty of the internet also made it difficult for investors and lenders to assess the viability of internet-based business plans. A change to the tax code reducing tax rates for capital gains also encouraged heavier speculation.

Between 1995 and 2000, the Nasdaq composite index saw a 400% increase in its value, only for it to fall 78% from its peak, with some businesses losing more than 80% of their stock values.

The bubble burst due to volatile spending on technology. Rising interest rates also made it more difficult for internet businesses, which typically operated at a loss, to borrow money to fund continued operations. An article featured in Barron’s in March 2000 also predicted issues with internet companies burning through their cash.

These factors combined damaged investor confidence and led to the bubble popping.

U.S. Housing Bubble

The U.S. housing bubble occurred in the early and mid-2000s, with housing prices peaking in 2006. The bursting of the bubble was one of the primary causes of the Great Recession.

The causes of the bubble are complex. Some of the factors include:

  • Tax code changes allowing homeowners to exclude significant gains from the sale of their home from capital gains taxes.
  • Deregulation of the financial industry allowing for adjustable-rate mortgages and deregulating bank interest rates
  • Loosened lending standards
  • Increased subprime lending
  • Historically low interest rates
  • Promotion of housing as an investment leading to a homeownership mania
  • Securitization of mortgages, credit default swaps, and collateralized debt obligations

During the bubble period, some major cities saw home values rise by 80% or more.

The bubble popped as interest rates rose, foreclosures increased and the subprime mortgage industry collapsed. More than 25 subprime lenders declared bankruptcy in 2007.

What Happens When a Stock Market Bubble Bursts?

When an economic bubble bursts, it can have wide-ranging effects. Even if it’s a stock market bubble constrained to one industry, it can affect the entire economy.

In general, when financial bubbles burst, investors panic and begin selling off their assets. With more sellers than buyers, share prices fall. The market as a whole will usually see price decreases as the panic spreads to other sectors.

Depending on the source of the bubble and the extent to which prices fall, it can impact the broader economy. For example, a housing market bubble can lead to foreclosures, which can force people out of their homes and damage the whole economy. By comparison, tulip bulb mania in the Netherlands had minimal impact on its overall economy.

Eventually, once the bubble bursts, the economy will begin to recover and asset prices return to more reasonable levels.

How to Invest During a Stock Market Bubble

Even during a stock market bubble, there are opportunities to invest and earn a profit.

One strategy is to look for short-term investments that you can buy and sell quickly before the bubble bursts. This can be risky, but highly profitable if you succeed.

You can also look for long-term opportunities. Look for companies that were successful and saw price increases even before the bubble period. These likely aren’t the most exciting companies in the market. Many are established blue chips, but they’ll have a good chance of weathering the storm when the bubble bursts.

Buying these blue chip stocks when the bubble bursts can be a good way to buy shares in solid companies at a discount.

Final Word

Stock market bubbles can happen in any industry and for all sorts of reasons. Identifying bubbles, and especially identifying when they’re reaching their peak, can be incredibly difficult. However, if you can identify bubbles as they’re happening it can help shield you from significant investment losses.

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