A stock market bubble is a rapid rise in the price of stocks or other assets that is not justified by fundamentals and is followed by a sharp decline in prices once investor enthusiasm wanes.
Bubbles are largely driven by investor sentiment and psychology, which generate a positive feedback loop of rising prices and additional buying. As the price of a stock or other asset rises, more and more investors see rising prices as an opportunity for profit. Further buying pushes prices even higher, attracting more investors as the bubble expands. Eventually, the bubble bursts when a sufficient number of investors realize that the price of the asset has become detached from its true value and begin to sell all of a sudden.
Much of the formation of market bubbles involves assets becoming significantly overvalued relative to their true value. As Nobel Prize-winning economist Robert Shiller wrote in his book Irrational Exuberance, many investors who have doubts about the underlying nature value of an asset are also sucked into a stock market bubble.
“I define a speculative bubble as a situation in which news of price increases stimulates investor enthusiasm, which spreads by psychological contagion from person to person, thus amplifying stories that could justify price increases. price and attracting an ever-wider class of investors. , who, despite having doubts about the real value of an investment, are drawn to it partly by envy of the successes of others and partly by the excitement of a player,” writes Shiller.
Part of it apparently irrational behavior is a phenomenon known as the “biggest fool theory”. According to the biggest fool theory, investors often buy assets at prices they know are unduly high simply in the hope that they will eventually have the opportunity to sell the assets at even higher prices at a buyer behaving even more stupidly than them.
Simply because the price of S&P500 or another asset has appreciated significantly does not necessarily mean that the market is in a bubble. The S&P 500 has averaged an annual gain of just over 10% since 1926 and has more than tripled over the past decade. However, much of the S&P 500’s price appreciation over the past few decades has been driven by the underlying long-term earnings growth of its component companies. A bull market is an extended period in which asset prices rise. Bubbles occur when these assets rise sharply without an underlying fundamental rationale, such as earnings growth, to justify these price gains.
Recognizing a stock market bubble in real time and predicting its bursting is very difficult, but investors should watch out for some red flags. Bubbles are usually marked by a prevalent story, such as the idea that a new Technology or a new way of thinking has definitely transformed the market.
At the peak of stock market bubbles, prices often continue to rise even in the face of bad news, such as earnings analyst failures or downgrades. Finally, bubbles are often marked by large groups of novice or amateur investors who believe that experienced investors are lagging behind or simply don’t understand the new market paradigm that is driving prices up.
American economist Hyman Minsky described the five stages of a market bubble in his 1986 book “Stabilizing an Unstable Economy”:
- Profit taking.
The first of Minsky’s stages is the “shift,” a change or series of changes that alters the way investors view the market. The second stage is the “boom”, during which the appreciation of asset prices accelerates, attracting speculative investors. In the third stage, “euphoria,” frantic buying is driven more by investor greed and excitement than by fundamental analysis. Once asset prices have risen enough, investors begin to reap huge gains during the “take profit” phase of the bubble. Finally, investors fearfully sell their assets at any price to avoid further losses during the final phase of a bubble bursting – the “panic” phase.
During the euphoria phase of a market bubble, one of the psychological phenomena that leads to accelerated buying is fear of missing out, or FOMO. FOMO occurs when investors who might otherwise not be interested in a particular stock or asset feel compelled to invest because they see how easily others are making money in the market. At the height of a financial market bubble, an outsider may feel that virtually every investor is getting richer and everyone on the sidelines is missing out on the opportunity of a lifetime. In reality, this stage of the bubble is often the worst time to buy.
Depending on your specific investment strategy, market bubbles can be great opportunities, disastrous traps, or anything in between. By recognizing the warning signs of a stock market bubble and understanding the stages of a bubble, investors can ensure they don’t fall prey to the psychological biases that often lead people to make the worst business decisions. investment at the worst times. For many diversified investors, the best approach may be to simply ignore the ups and downs of the stock market and focus on discipline with a long-term investment plan.
Investors can make a lot of money in the market during the early stages of a stock market bubble. In addition, quality companies may take advantage of inflated stock prices to issue equity offerings, sell shares to raise the cash they need to invest in future growth or pay down debt. Market bubbles also typically bring new groups of investors into the market for the first time, and those undeterred by the bubble’s short-term volatility may end up being better off financially in the long run because they started to invest.
Unfortunately, many investors end up losing a lot of money during stock market bubbles because they only start buying when asset prices are already significantly overvalued. The bursting of market bubbles can also threaten the stability of the financial system or the economy as a whole, as investors witnessed during the bursting of the mortgage bubble in 2008 and 2009. Finally, the extreme Price volatility associated with bubbles can disillusion investors with the market. in general, especially when it seems that asset prices have almost no relationship to real value.
“Tulip mania” is one of the earliest examples of market bubbles, dating back to the 1630s in Holland. At the height of the tulip bulb market bubble, prices for some of the most prized tulip bulbs were roughly equal to the price of a nice house in Holland at the time. During the dot. profits. When the dot-com bubble burst in 2000, the Nasdaq Composite Index fell nearly 80% over the next two years. The bursting of a bubble in the US housing market in the mid-2000s ultimately triggered the subprime mortgage crisis of 2007–2010, during which banks overexposed to the mortgage derivatives market eventually had to be bailed out by the US government to preserve the integrity of the global financial system.
It is very difficult to predict when a bubble will burst. Economist John Maynard Keynes said: “Markets can stay irrational longer than you can stay solvent.