Stock market bubble
A
stock market bubble is a type of
economic bubble taking place in
stock markets, in which a wave of
public enthusiasm, evolving into
herd behavior, causes an exaggerated
bull market. When such a bubble takes place,
market prices of listed
stocks rise dramatically, making them significantly overvalued by any measure of
stock valuation. Generally stock market bubbles are followed by
stock market crashes.
Stock market bubbles are inconsistent with the "Efficient Markets Hypothesis," which makes their existence a matter of some debate.
Some of those bubbles are created because of intense and excessive
speculation on a new technology or service. The
Dot-com bubble of the late 1990s is one example [
1]. The
biotech boom in the 1980s is another. Still other examples of stock market bubbles include Japanese stocks in the late 1980s,
Nifty Fifty stocks in the early 1970s, and
Taiwanese stocks in 1987.
Stock market bubbles frequently produce hot markets in Initial Public Offerings, since investment bankers and their clients see opportunities to create new stocks they can then sell at inflated prices. These hot IPO markets misallocate investment funds to areas dictated by speculative trends, rather than the fundamental abilities of assets to generate real returns.
Some of the first documented economic bubbles were the
South Sea bubble in
England in the
1700s and the
Tulip bulb bubble in
Holland in the
1600s.
A stock market bubble may set the stage for a later
stock market crash, continuing our example, the
Stock market downturn of 2002.
Emotional and cognitive biases (see
behavioral finance) seem to be the causes of bubbles. But, often, when the phenomenon appears, pundits try to find a rationale, so as not to be against the crowd. Thus, sometimes, people will dismiss concerns about overpriced markets by citing a
new economy where the old stock valuation rules may no longer apply. This type of thinking helps to further propagate the bubble whereby everyone is investing with the intent of finding a
greater fool. Still, some analysts cite the wisdom of crowds and say that price movements really do reflect rational expectations of fundamental returns.
To sort out the competing claims between behavioral finance and efficient markets theorists, observers need to find bubbles that occur when a readily-available measure of fundamental value is also observable. The bubble in closed-end country funds in the late 1980s is instructive here, as are the bubbles that occur in experimental asset markets. For closed-end country funds, observers can compare the stock prices to the net asset value per share (the net value of the fund's total holdings divided by the number of shares outstanding). For experimental asset markets, observers can compare the stock prices to the expected returns from holding the stock (which the experimenter determines and communicates to the traders).
In both instances, closed-end country funds and experimental markets, stock prices clearly diverge from fundamental values. Dr. Vernon Smith has illustrated the closed-end country fund phenomenon with a chart showing prices and net asset values of the Spain Fund in 1989 and 1990 in his work on price bubbles. At its peak, the Spain Fund traded near $35, nearly triple its Net Asset Value of about $12 per share. At the same time the Spain Fund and other closed-end country funds were trading at very substantial premiums, the number of closed-end country funds available exploded thanks to many issuers creating new country funds and selling the IPOs at high premiums.
It only took a few months for the premiums in closed-end country funds to fade back to the more typical discounts that closed-end funds trade at. The fools that bought them at premiums had run out of greater fools. For a while, though, the supply of greater fools had been outstanding.
*
Collective behavior*
Tulip mania*
Fictitious capital*
The South Sea Company*
Mississippi Company*
Railway Mania*
Poseidon bubble*
Market trends* Accounts of the
South Sea Bubble,
John Law and the
Mississippi Company, and the
tulip mania can be read in
Charles Mackay's classic
Extraordinary Popular Delusions and the Madness of Crowds (1843) -
available from Project Gutenberg.
*
the compelling Real DJIA, 1924-now*
the 3 Fed Chair warnings, Real DJIAThe Spain Fund chart from Vernon Smith, Nobel Laureate in Economics for his work in experimental markets, including bubbles:www.lgt-capital-management.com/cm/en/downloads/dok_imagebrochure/BEHAVIORAL_FINANCE_BROSCHxRE_ENG_3.2.04.pdf
