Stock Market Bubbles: A Complete Guide

The stock market is like a roller coaster.

It comes with many ups, downs, and unpredictable movements that may leave you feeling queasy.

If you take a look at any of the most recent financial news programs, you would hear the anchors shouting about which stocks are up, which are down, and why — quite a typical working day in the markets. 📰

However, sometimes these fluctuations can get out of hand. Take unprecedented increases, for example. One day you wake up, and the price of a stock you hold has tripled in price. And just as you think the price is going to level out, it doesn’t – instead it keeps going up.

For an investor, an increase in prices could indicate a bull market which is every investor’s dream. However, when prices rise to a level that doesn’t correspond to the value of the underlying company, then a problem might be brewing. 

For instance, the stock market went into a freefall in early 2020 due to the pandemic. While the aftershock left the economy on its knees with rising inflation and the worrying levels of unemployment, the stock market was, surprisingly, reaching record heights. 📈

At the time, many market strategists warned that all might not be well. And true to their words, the markets have started to feel the pressure. By May 2022, at least 50% of the market is reported approaching or already experiencing a bubble.

Keep reading to learn more about how a stock market bubble happens, what you can do to properly prepare, and how you can still make money — even if the outlook seems bleak.

What is a Stock Market Bubble? 📚

A stock market bubble is an unjustifiable instantaneous rise in stock prices. It is quickly followed by a sharp drop in prices — as the investor’s speculative frenzy and enthusiasm wear out. 

Market bubbles are mainly a result of investors’ sentiment or psychology. In other words, bubbles are driven primarily by investors who buy stocks or other asset classes without considering their value. As the prices increase, investors continue to buy and accumulate more stocks viewing the increase as an opportunity to make a profit.  

As the investors continue to purchase more shares, prices are pushed up even further, attracting even more investors and inflating the bubble further. Eventually, the stock prices vastly outweigh the underlying value of the companies whose stocks they represent.

But as soon as the investors’ enthusiasm wanes and they start to realize that the stock is not worth its cost, the bubble bursts, and they all begin to sell. 

What Causes Bubbles to Occur? 🤔

As Seth Klarman once said, “At the root of all financial bubbles is a good idea carried to excess.” 

A market bubble is fueled by speculation or exuberant market behavior. A bubble starts to form when there is an unjustifiable acceleration in the price of an asset that dramatically exceeds the asset’s intrinsic value. 

That means investors are willing to pay much more for an asset – beyond normal expectations. 

The collective enthusiasm by traders to buy a stock when prices are rising can be attributed to many factors — many of which are debatable. Some economists attribute this behavior to what is known as crowd mentality, the bandwagon effect, or FOMO.

Some people want to invest in an asset because the prices are rising, or because others are buying in. This drives the prices even higher.

How Do Stock Market Bubbles Work? 👷‍♂️

In his book “Irrational Exuberance,” Nobel Prize-winning economist Robert Shiller mentions that most investors are sucked into a bubble due to their doubts about the actual value of an asset. 

He says that a speculative market bubble is a situation in which the increase in prices causes increased investor enthusiasm, which is spread through psychological contagion from one individual to another. 

It creates a religion-like spell which is then spread to justify the increase in prices. Eventually, more and more investors are lured in. This can be because of fear of missing out (FOMO) or due to sheer ‘gambler’s excitement. 

Irrational behavior can easily be linked to a phenomenon known as the “greater fool theory.” According to this theory, an investor is likely to buy an asset at a price unjustifiably high, hoping the prices will go even higher so they can sell to a more foolish buyer and profit. 

Difference Between a Bull Market and a Bubble 🐂

It is crucial to remember that although the price of a stock or other assets has increased significantly, it doesn’t necessarily mean the market is in a bubble. 

For example, prices are expected to increase following a recession or a bear market for the market to recover. Other times it is a sign of a healthy correction for the stock market.

In fact, some stock prices are naturally expected to grow with time. For example, the S&P 500 has gained an average of 10% annually since 1926 and has tripled in price in the past decade alone. The increase in the last decade can be attributed to its component companies’ fundamental long-term profit growth.

A bull market refers to a prolonged period of increasing asset prices. Bubbles emerge when the costs of these assets rise rapidly without a fundamental basis, such as profit growth, to justify these price increases.

Different Types of Bubbles 🗃

Humans are unpredictable beings. As long as ambition and enthusiasm exist, market bubbles can occur anywhere. 

A speculative frenzy can cause bubbles even in the most unexpected facets of the economy, from the overnight demand for cryptocurrency to housing and even to tulip bulbs that saw a rare tulip bulb cost as much as the price of an apartment in downtown New York. 

In economics, asset bubbles are broken down into four simple categories:

Stock Market Bubble 📊

This involves the equities market. In this kind of bubble, the value of stocks rises rapidly and out of proportion with the fundamental value of the underlying companies. A stock market bubble is susceptible to a fall if market traders conclude that bubble values are too inflated.

An excellent example of a stock market bubble is the famous dot-com bubble. In the late 1990s, the “dotcoms” took the world by storm. Within a short time, any company with a “.com” in its name was treated as hot cake in the stock market — even those that couldn’t produce a viable business plan, let alone have tangible physical assets. 

By 2021, many investors had already grown tired of waiting for profits from these companies and thus started selling. This became the start of a mild recession in the United States and a few other developed countries. 

Asset Market Bubbles 🏠

An asset market bubble increases prices in other markets and sections of the economy other than the stock market. An excellent example of an asset market bubble is a housing bubble in the real estate industry. 

An even better example is the cryptocurrency market. Last month, the price of Bitcoin went up 40% from a year ago. In fact, some cryptocurrencies have seen their price surge by up to 18,000%.

As a result of the constant increase in prices of many digital coins, especially Bitcoin, even the world’s savviest cryptocurrency investors were hooked. 

However, as the billionaire Charlie Munger once said, the crypto market could be “… even crazier than the dot-com era.”

And true to his words, the market is currently in big trouble. In the last few weeks, Bitcoin has fallen from a high of $69,000 in Nov 2021 to a current low of $27,000. LUNA, a native of the Terra ecosystem, went from $85 to $0.0001644 in just a few nights.

Credit Bubbles 💳

This bubble affects the borrowing industry/credit market — the increase in demand for personal and business loans and other credit instruments. People borrow more to finance increased consumer spending. 

Historically, credit bubbles have alternated between booms and bursts. These fluctuations have become even more common in the recent past, and changes in various critical economic variables accompany them.

For instance, rapid credit growth is accompanied by an increase in asset prices and growth in real GDP, exaggerated consumption, and an increase in investment. 

But although this might look like a dream come true for any economy, it is not exactly a good thing. This is because the boom will come to an end at some point. Once the boom ends, the aftermath will be riddled with low economic growth and a possible financial crisis.

Commodity Bubbles 🛢

Tangible goods/resources are traded in the commodity market, e.g., precious metals, oil, agricultural crops, etc. Therefore, a commodity bubble occurs when the value of commodities increases exponentially. 

A good example is what is known as the ‘Tulipmania.’ In the early 1600s, speculation drove the price of tulips to the extremes in Holland. A flower that came into the country through spice trading routes soon became a symbol of ultimate luxury. 

This led to all middle classes of Dutch society doing everything possible to get their hands on this rare commodity. This demand led to the prices of tulips skyrocketing.

But soon, the Dutch learned that this unbelievable symbol of class could be grown from seeds or buds harvested from the mother bulb. This saw yet another extreme demand for “broken bulb” tulips which was also accompanied by high market prices. 

This persisted until late 1637 when buyers started questioning the value of the tulips. Soon, no one could pay the high price, making the tulip market fall apart. 

Important Indicators of a Stock Market Bubble 🌟

As they say, nobody rings a bell at the bottom, or at the top for that matter. In most cases, those who try to second guess a market trend often get their heads handed to them on a plate. 

But — and it’s a big but — there are several tell-a-tale signs that sophisticated investors use to determine when a market is approaching nosebleed territory. So here are some signs to look out for to help shield a portfolio from the hot before cold market dynamics. 

Compelling Story 📘

Behind every bubble is a well-curated believable story. Here are the notable real-life examples of great compelling stories behind a market bubble:

• ☑ The dot-com bubble in late 1990: “The internet changes everything.”
• ☑ The housing bubble in the early 2000s: “Real estate never declines in price.”
• ☑ The 19th century’s railway mania: “Railway is the future of travel and transportation.”

While these stories do hold some truth, we cannot ignore the damaging effects they cause.

For instance, no one can imagine life without the internet today – proving that this invention really did “change everything”. 

But before achieving this stability, the stock market was thrown into chaos during the dot-com crash, with stock prices falling dramatically —  especially the stocks in the overhyped sectors. This was after most of the shaky companies with poor business models were kicked entirely out of the market. 

Recently, there have been a few notable trends. Uber and cryptocurrencies are the most recent sectors with the same storyline as the dot-com era — promising revolutionary changes and charging an arm and a leg in return. 

Rising of Price 💹

The story stands at the core of investors’ hopes and dreams. It illuminates the way and guards the promise for radical changes. However, in a regular market, the expectations are that the investors would be forced to adjust their expectations if the story does not match the reality, right? 

Unfortunately, this is not always the case. In a market bubble, every bit of information seemingly matches the story, and the prices increase despite any differing information. Did the company meet its revenue targets? Prices go up. Did the company revenue go down by half? The prices still go up. 

The story stands, and this continues for a while. Consequently, astute investors calibrate reality to the narrative to determine if they match. When the stock market rises, but the long-term outlook worsens, long-term investors are highly cautious.

This has been happening a lot lately. For example, even amidst the pandemic, prices of various stocks have been on the rise. But investors investing in the stocks are banking on the future recovery of the underlying companies. 

For example, investors are flocking to the stocks of electric vehicle maker companies, and some companies with minimal or no production are getting valued quite highly. 

Other Asset Prices Soaring 💸

In a market bubble where stock prices are soaring, prices of other asset prices are possibly increasing in tandem. 

Promoters take advantage of such bubbles to hype other assets. They can be found in every corner highlighting how cryptocurrency is the next big thing or how Gold is the new money marker.

As speculators generate profits when deciding to sell their stocks again, they are likely to jump into the next available vehicle and invest in these higher-risk assets.

There are hundreds of real-life examples of such in the current market conditions. In the last few years, the crypto industry has witnessed an enormous number of such promoters and speculators alike. In early 2022, the crypto industry was valued at a whopping $2 trillion, with Bitcoin holding the majority of this amount. 

The interest is not in the digital currency only. Many assets have piqued the interest of even the most sophisticated investors — luxury handbags, shoes, wine, video game cartridges, and the list goes on and on.  

Everyone “Understands” the Markets 🤓

The ‘old school’ understands the market better. Long-term investors like Warren Buffett have seen it all. They have endured all the craziness that came with the dot-com debacle, the spectacle created by the housing industry in the early 2000s, and everything in between. 

Warren Buffet even took advantage and profited from failing banks that needed cash and confidence in 2008. 

Even when it’s evident that experience matters in this industry, younger, less experienced investors will beat their chests, armed with the right market analysis tools, and claim that the older generation ‘don’t get it.’ Although they might have been in the market for only a few months, they claim to understand the market better than the ‘old school.’ But seasoned investors are not willing to bet on the market.

Stock Valuations 📜

During a stock market bubble, the prices are inconceivably high in relation to reality — usually at the highest percentile historically. By analyzing comparisons to past bubbles, you may determine if a solid bull run will burst or persist.

Keep in mind that an increase in prices only can’t be used to define a bubble. If the underlying fundamentals can support the rise in prices, even a 100% increase can’t be termed a stock market bubble. 

For instance, if we start from a low value (such as the pandemic’s low point) and then measure after a bull run, we’ll get flashy numbers that would suggest a bubble. But in reality, it could just be the market recovering from being bearish. 

Extrapolating the S&P 500’s pre-pandemic high in February 2020 to today’s pricing yields a 32% increase. If we measure off 2020’s lows, we may think the market is irresponsibly optimistic, while the reality is, it’s more optimistic than normal.

Stages of a Market Bubble 👨‍🏫

In his book ‘Stabilizing an Unstable Economy (1986),’ Economist Hyman P. Minsky explains the five stages in a typical credit cycle (stages of a market bubble) as: 

Displacement 👨‍💻

A displacement occurs when people fall in love with a new paradigm, such as a new product or a new inventive technology. Sometimes it is a result of a significant change in the economy that affects an otherwise perfectly secular market.

In the case of tulips in Holland during the 1600s, the country was experiencing robust economic expansion as a result of a surge in international trade. Since tulips were rare, took a long time to develop, and were viewed as a symbol of luxury, they were the ideal candidates for inciting a frenzy among the Dutch.

Boom 💥

During the displacement phase, moderate price increases begin to occur. As more and more customers join the party during the boom phase, prices grow rapidly. This is typically when the mainstream media begins to cover the topic and “ordinary” people become interested.

Behavioral biases such as “The Fear of Missing Out (FOMO)” are the earliest indications of a financial bubble. This is the phase where speculation truly takes flight. For instance, even though tulips arrived in Holland at the end of the 1600, the tulip boom occurred between 1634 and 1637.

Euphoria 🙌

Here, investors throw caution to the wind, and asset prices surge. Investors have made so much money on their investments that they cannot conceive of a market decline, and they tell everyone they know. This is the phase in which the uncle, next-door neighbor, the hairdresser and even the cab driver urge you to participate. 

Those who purchase during the euphoria phase are unaware that the only way to gain money is if someone else decides to purchase after them – a concept known as the Greater Fool Theory. But who will be your next customer if everyone is already playing?

For example, at the pinnacle of the Japanese real estate boom in 1989, Tokyo land sold for $139,000 per square foot or 350 times Manhattan property when the bubble burst, real estate lost 80% of its inflated value as the bubble burst, while stocks fell 70%.

Profit-Taking 💰

By this phase, wise investors have already noticed that the price increase is not sustainable, so they sell out and take the profits. However, it is never easy to estimate the exact moment when the bubble will burst. 

Going back to the story of the tulip, the market dealers were the first to sense danger. Hence they were the first to dispose of their tulip stocks. This was because, in that market, only the dealer had vital information regarding the buyers and sellers of the tulips. 

In a bubbling market, even the smallest unfriendly event can prick the bubble, and once it’s pricked, there is no going back. 

Panic 😱

When individuals discover that everyone is selling, panic ensues, and few options remain. Suppose you were waiting in line to enter Disney World when you witnessed a mass exodus of terrified guests. What would you do?

You would probably start running like everyone else. As a result of widespread fear in 1637, the price of tulips plummeted within a few months, and individuals who had purchased at the peak price were forced to sell for less than a quarter of what they had spent.

Another vivid example is in 2008, after Lehman Brothers declared bankruptcy and Fannie Mae, Freddie Mac, and AIG nearly imploded, global financial markets panicked. This was the ninth-worst month for the S&P 500. Global equity markets lost $22 trillion, or 9.3 trillion, in one month.

Importance of Understanding Stock Market Bubbles 🧐

The stock market is famous for its volatility. In addition, it is almost impossible to tell in real-time whether the market is experiencing a bubble, except in retrospect.

However, for an investor hoping to protect their portfolio, it is crucial to at least have the basic knowledge of a bubbling market. Recognizing a market bubble allows an investor to:

• ☑ Prepare for the possible market decline. By recognizing a market bubble, an investor can avoid it. He can study the risks and prepare accordingly in order to guide their portfolio through a bubble. For example, an investor can shift their assets from high-risk to low-risk options, or even exit the market entirely. Even if they choose to ride the bubble, they will have the information to help them know when to abandon a ship. 
• ☑ Avoid losing money. While many speculators gain money during a bubble, only those who realize that they are trading in a bubbling market and refrain from reinvesting in bubble stocks actually keep their money. Recognizing a bubble lets you stay cautious and always be prepared for the burst. 
• ☑ Ready your personal finances. Historically stock market bubbles are known to have severe spillover effects on the general economy. Typically, after a market bubble bursts, it precedes a downturn in the economy, leading to a full recession. Like in the case of the dot-com bubble burst which saw the start of the recession in the early 2000s. So predicting a stock market bubble can give an investor a chance to prepare their finances for when the economy takes a nosedive.

Although they have to make a full prediction, experts are able to tell when there is an imminent danger. For instance, there have been many predictions in the last few months that the current stock market might be approaching or already in a bubble.

Pros and Cons of Stock Market Bubbles ⚖

While market bubbles can present a profitable opportunity for investors, they also come with major downsides that tend to have a lasting effect. 

High Profits 💵

Speculators can make a killing at the early stages of a stock market bubble – especially those with reliable stock brokers who can guide them through the bubble. 

The market is booming, and the prices are on an upward spiral. If shrewd speculators take advantage of such market dynamics, they can make plenty of money before the bubble pops.

In addition, companies can take advantage of the high stock prices to issue equity offerings. This allows them to raise money quickly for future growth or to service existing debt. 

Bubbles Leave Behind New Commercial and Consumer Infrastructure 📃

In his book, Pop! Why Bubbles are Great for the Economy, Daniel Gross analyses some of the most notable bubbles in the US economy, starting from the frenzied railroad overbuilding in the 1880s to the recent dot-com delirium of the 1990s. 

Conclusion: despite the possible damage to underlying companies and massive losses to the investors, bubbles play a necessary role in the health of the US economy. In his view, once the bubbles burst, the infrastructure left behind can quickly get reused by entrepreneurs with better business structures. 

And when new businesses and services are launched on these now improved infrastructures, the economy can benefit from the chaos caused by the market bubble. 

Encourages Market Growth ↗

During a stock market bubble, information tends to spill over to the mainstream, which in return attracts all kinds of new investors looking for a quick buck – including margin traders. In this period, even the local hairdresser will likely pump you up with investment tips and encourage you to take the risk.

Investors who join the market during a bubble and are not discouraged by the market volatility may end up making a lot of money in the stock market just because they chose to ride the bubble. 

Cons ⚠

When an asset bubble bursts, as it usually does, a number of things can happen. Sometimes the impact is minimal, affecting only a few people. However, it can also result in a stock market crash, a downturn in the economy as a whole, or even a depression.

Can Lead to Massive Losses 📉

During a bubble, some investors take their time before they allow themselves to be swept by the tide — especially those who are more risk-averse. 

By the time they are ready to bite in, the prices are already significantly overvalued, and the market bubble is about to burst. This can lead to severe losses for such investors once the bubble bursts. 

Disrupts Financial Systems and the Economy in General 🏦

Market bubbles and recessions always come in pairs. Most of the bubbles witnessed in history have always followed a mild or full recession. 

A good example is the housing bubble in 2008 and 2009: in December 2008, Case–Shiller home price index reported the highest price drop in history. The credit crisis that followed the bubble burst marked the start of the Great Recession in the United States.

Examples of Famous Market Bubbles 📝

There have been plenty of stock market bubbles throughout history, but in this section we will cover three of the most prominent ones:

The South Sea Bubble 🌊

The South Sea Company was founded in 1711 to capitalize on a commercial monopoly with the Spanish territories in South America. Thousands of excited investors flocked to the stock, which offered a guaranteed return of 6% after the company’s directors promised huge returns on investment. 

The bubble peaked in 1720 after the British Parliament accepted the company’s proposition to assume the national debt.

In the summer of 1720, South Sea Company shares soared from £128 in January to £1,050. It was so successful that it spawned several additional stock companies with similar objectives, including some to rebuild vicarage homes and — most notably — “a business for carrying out an undertaking of immense advantage, although nobody knows what it is.” This unknown company’s subscriptions sold out.

The South Sea bubble subsequently burst. According to the UK National Archives, more than double the amount of accessible shares was sold to the public. The proceeds were distributed to the investors who held positions first.

The Dot-com Bubble 🌐

In the late 90s and early 2000, the allure of the internet led some investors to purchase anything remotely related to it, even when the company lacked a solid and verifiable business model. This was caused by high speculative behaviors by investors who claimed that the internet would change everything. 

The result was an increased demand for stocks of tech startups, which pushed the value of their shares to higher levels. Many companies went ahead to change their names to include “.com,” or “.net.” This simple change only, could make a company outperform its competitors by over 60% during that period. 

Soon, the market took a nosedive after most investors realized that the companies they invested in had no hope of ever turning over any profit. 

While certain corporate titans, such as Amazon, finally emerged from the bubble, the majority of dotcoms quickly died a quick death after the bubble burst. Other surviving dotcom enterprises lost at least 90% of their value and never fully recovered from the destruction. 

Lately, SaaS companies have seen massive growth and experts are worried it might be the start of another dot-com bubble.

The Real Estate Bubble 🏢

Ever heard of the black swan event? Immediately after the dot-com bubble, housing market prices shot up within a short timeframe. 

This increase was mainly fueled by low loan rates (which existed to cushion the crash’s impact) and the assumption that real estate never loses value. Financial institutions were offering loans to everyone, including those with bad credit. 

Stocks of numerous real estate-related enterprises, including construction firms, banks, and a range of specialized financiers, rose in tandem with the increase in housing prices. 

But when most of the borrowers defaulted, it caused a ripple effect, leading to a market crash. Property values plunged, and homeowners and banks were left with significantly less valuable assets than when they were acquired. The economic impact of the subsequent catastrophe lasted for many years.

How to Trade During a Stock Market Bubble

It is possible to trade safely during a stock market bubble. Here are some tips to help you stay ahead of the pack:

• ☑ Stay risk-aware. Avoid getting swept up by the euphoria of a soaring market. Consider investing in a variety of equity funds and reduce exposure to growth stocks to try to spread the risk.
• ☑ Focus on the fundamentals. Even though it’s good to responsibly research and bet on the market, investors should never forget the fundamental aspects of the underlying company. They should keep monitoring the company’s asset accumulation, revenue, and profits as well as its customer base. Ensuring there is no unnecessary overstretching. 
• ☑ Go Short. Investors could consider short selling since it allows them to capitalize on declining prices. While shorting enables an investor to profit from a burst bubble, it is vital to keep in mind that prices might reverse direction at any time. 
  Developing an efficient risk management approach is essential for minimizing possible losses and safeguarding earnings. If an investor decides to sell short, they should always remember the uptick rule and keep ahead of the market. 
• ☑ Think long-term. A long-term investing strategy entails defining and adhering to a strategy. It may be essential to recall that markets move through cycles at this time.
• ☑ Try the contrarian approach. If a bubble bursts and people start selling out of fear, suave investors might be able to find deals on stocks that they think are good and that they believe in for the long term. Although they also carry risk, buying undervalued stocks of a promising company can be their chance to grow their portfolio in the said industry. 

Conclusion 🏁

This quote summarizes the stock market bubble. A bubble starts with little increase in prices that is then fueled by investors’ sentiment or psychology. Before long the prices get unjustifiably high. 

 “Human nature being what it is, small loopholes are likely to be exploited until they become big ones, and big ones until they turn into financial disasters.”

Seth Klarman

When investors determine that stock prices vastly surpass their underlying value and begin selling their shares, a major sell-off ensues, bursting the bubble and trapping those who are unable to sell their shares quickly enough.

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