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What Is a Stock Market Bubble and How Does It Happen?

If you follow investing and the stock market, you no doubt have come across the phrase “we’re in a bubble” or the “the bubble will burst” and so on.

A stock market is a dynamic place where traders and inverters buy and sell shares in various companies. Their goal is to make a profit or build wealth in the long term. Moreover, traders and investors speculate on stock prices and try to find ways to predict where prices may go. If you’re new to the game, platforms like buystocks.co.uk can help you play the stock market.

Every so often, a stock market bubble forms. Here, the value of the stock prices surpasses the intrinsic value of the stock. Bubbles can occur between different companies, indexes, or even the whole stock market.

When a bubble bursts, it can have devastating consequences for investors and the economy as a whole. As an investor, it’s wise to understand what is a stock market bubble and how they occur.

In this article, we’ll discuss:

What is a Stock Market Bubble?

A stock market bubble is also referred to as a speculative bubble. Speculation in investing is the main factor in how the markets operate. As investors try to predict where the market might lead, they speculate on the price.

With bubbles, the continued rise of stock or index value will move beyond the intrinsic value of that stock or index.

Eventually, the bubble bursts, and what follows is a dramatic sell-off. Often referred to as a crash, stocks plummet, and the investors still holding will lose money. A stock market crash causes intense economic damage and can affect not just the stock market, but a whole economy.

Although bubbles generally refer to the stock market, bubbles may form in other assets classes such as real estate and cryptocurrencies.

How Do Bubbles Happen?

There are many theories about how stock market bubbles occur. Economists agree that a form of herd mentality seems to take over when assets prices keep rising. No one wants to miss out on big earnings, so more jump in. And then a crash transpires, the herd makes a run for it.

Some of the factors involved in forming stock market bubbles include:

  • Low-interest rates
  • Supply chain disruptions
  • Borrowers overextend themselves and increase the debt
  • The introduction of innovation that breeds excitement

Four main types of bubbles may happen due to a variety of speculative factors:

1. Asset Market Bubbles

This involves industries outside of the stock or equities markets. For example, real estate and cryptocurrencies like Bitcoin and Ethereum.

2. Stock Market Bubbles

These bubbles we have already discussed revolve around stock prices.

3. Commodity Bubbles

Commodity bubbles occur when the price of traded commodities like gold, palladium, or oil rises rapidly.

4. Credit Bubbles

Here, the increased issuing of loans and mortgages to individuals and businesses moves into dangerous territory.

The Five Bubble Stages

In his book Stabilising an Unstable Economy (1986), American economist Hyman Minsky wrote about five stages in a bubble’s cycle:

1. Displacement

Displacement is when a series of changes in either policy or technology causes investors to speculate more about an asset’s value.

2. Boom

The boom happens when the asset price starts rising and keeps going for an extended period, attracting more investors.

3. Euphoria

Here is when the asset price accelerates faster, and investors get over-excited. Despite the risks, herd mentality sets in.

4. Profit-taking

The value of the asset price exceeds limits that buyers cannot handle, and investors begin to sell off their stocks. Investors try to predict when the bubble will burst and save their profits.

5. Panic

As the price starts to fall, investors panic and start selling off in large numbers to stop losing money. The sell-offs spiral out of control and cause a crash.

How to Predict a Stock Market Bubble

Understanding how and when a stock market bubble happens is vital to long-term investing. Predicting how a market will move will help secure your assets in the long run.

Here are five indicators to consider:

  1. Historic Valuations: Looking at the past price history, you can assess whether the market can sustain the current price levels
  1. Stock values unaffected by news: When the price strays too far from its intrinsic value despite news and rumors.
  1. Investors vs. the public: When an asset class brings in more beginner or first-time traders than experienced investors, this is a sign of unrealizable speculation.
  1. A compelling story: News of innovations that might change the world promising benefits that can’t be met.
  1. Other rising assets: You can tell a bubble is forming when multiple assets rise rapidly at the same time.

Final Thoughts

Stock Market Bubbles are a consequence of many factors, but all lead from market speculation. As investors try to increase profits, they will buy into trends and unnaturally inflate asset prices. When a bubble bursts, it can have damaging consequences. Be ahead of the herd studying market trends and spot bubbles before they pop.

 

 

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