Stock Market Bubble

A stock market bubble is a type kind of an economic bubble occurring in the stock market where market participants inflate stocks prices way beyond their intrinsic value or fair value.

According to behavioral finance theory, stock market bubbles are formed due to cognitive biases which leads to groupthink, or herd behavior.

However, these bubbles – driven by uncertainties and market grapevines and speculation – are not only seen in financial markets but also in foreseeable experimental markets.

Stock Market Bubble Examples:

Two of the most prominent stock markets bubbles bankrupting scores of investors were the Mississippi Scheme in France and the South Sea Bubble in England. Both of these bubbles that went burst in 1720 are described in Charles Mackay’s 1841 account, ‘Extraordinary Popular Delusions and the Madness of Crowds’, among many other such stories.

In the U.S. two of the most notorious stock markets bubbles ever to have occurred were in the 1920, just before the Great Depression and the Dotcom bubble of the late 1990’s. Both of these bubbles were results of rapid advancement in technology.

While in 1920 the world of technology witnessed new inventions ranging from radio, automobiles, aviation and the installation of power grids; the dotcom boom of late 1990’s saw rapid developments in internet related business and e-commerce technologies.

Some other financial market bubbles include Brazil’s Encilhamento which occurred between late 1880s and early 1890s, the Nifty Fifty stocks bubble in India during the early1970s, Taiwanese stocks in 1987 and the property boom in Japan in late 1980’s.

Typically, the stock market bubbles result in avalanche of Initial Public Offerings or IPO. An IPO is often preceded by hype and speculation. Accordingly, investment bankers and promoters inflate the prices of shares in order to tap maximum amount of funds from the market.

Sometimes mutual fund managers also play a significant role in a stock market bubble.  Investment managers are compensated and retained in part due to their portfolio’s performance relative to peers. So in order to maximize returns for clients, these fund managers can rationally invest in a market bubble which is about to come, just to make sure that do not miss out on opportunity where risks of not investing are outweighed by the benefits.

The funds generated in this fashion are routed towards those areas that are dictated by highly speculative trends instead of businesses creating long-term economic value.

Historically, a large number of IPOs during any bubble market or economic boom backed by cheap credit resulted in many miserable failures as companies do not achieve anything promised to investors. In some IPO cases, investing vehicles are for fraud.

Rationality or Irrationality

The bubbles are mainly formed due to emotional or cognitive biases- a condition where human fails to distinguish between rational and irrational decisions. For example, an individual will not ask herself the rationale behind investing in a particular sector or stock just because he/she doesn’t have to move in the opposite direction of the ‘herd’ or crowd.

In some cases investors will dismiss worries about overpriced IPOs by citing that new economy stocks cannot be calculated according to old valuation rules. As a result, an overpriced stock is further inflated, eventually creating a bubble market where one investor tries to find a bigger fool.

However, some analysts don’t consider it as irrational investing. Also known as efficient market theorists, their contention is that price changes in upward directions is a result of collective wisdom and it clearly indicate rational expectations of fundamental returns.

In order to differentiate competing claims between proponents of behavioral finance theory and efficient market theorists, market watchers need to recognize bubbles arising when a readily-available measure of essential value is also a visible fact.

The bubbles formed in closed end country funds in the late 1980’s and those that occur in experimental markets are perfect examples.  In closed end country funds, investors can compare the current stock prices to the net asset value per share. (NAV is calculated by dividing the funds total holdings by the total number of shares outstanding).

Again in experimental markets, investors can compare the current stock prices against the expected returns of the stocks.

In both of these instances, stock prices deviate from fundamental values.

In his work on stock market bubble, Noble laureate Dr. Vernon Smith explained the closed-end-country-funds phenomenon with a chart showing prices and net asset values of the Spain Fund in 1989 and 1990.  The Spain fund peaked at $35, almost climbing three times more than its net asset value of $12 a share.

During this period the Spain fund along with many other closed- end -country funds traded at significant premiums. Subsequently the number of closed-end country funds multiplied in the market thanks to a glut of issuers creating and selling to investors through IPOs at exorbitant premiums.

However, the bubble went burst as it took only few months for the premiums charged on closed-end-country funds to drop and trade at a discount- a rate which close end funds typically trade.

Positive Feedback Loop

Investors tend to be attracted towards rising prices of shares. Unfortunately, not many investors are willing or ready to study the intrinsic value of the share. For such investors, rapid gains in the price of a share itself are the reason enough to invest. As a result, more investments will further inflate the price of a share thereby completing a positive feedback loop.

Like other markets, financial markets also work under an ever-changing equilibrium, which results in price volatility. In a market economy, self adjustments or negative feedback takes place normally; that is, when prices rise, investors will be encouraged to sell even as fewer are interested in buying, thus limiting the market volatility.

On the other hand, when positive feedback takes over, the markets tend to work under increasing disequilibrium. The perfect example is a financial bubble- a phase when asset prices increase at a very rapid pace much beyond what could be deemed as a rational ‘economic value’, only to plunge steeply afterwards.