What Causes a Stock Market Bubble?

Stock market bubbles occur when speculative trading and investing, fueled by what could be called irrational exuberance, leads to big increases in values for certain assets. Those value increases may not necessarily be supported by much more than market euphoria, and assets can become overvalued. Eventually, the bubble “pops,” and asset values fall.

Market bubbles occur from time to time, and they aren’t always easy to recognize. They can have different causes, too. In all, it’s important for investors to understand what they are, how they happen, and how they can protect their portfolios from an eventual bubble burst.

What Is a Stock Market Bubble?

A stock market bubble is often caused by speculative investing. As investors bid up the stock price, it becomes detached from its real value. Eventually, the bubble bursts, and investors who bought high and didn’t sell fast enough are left holding shares they overpaid for.

Stock market bubbles are notoriously difficult to spot, but they’re famous for potentially causing large-scale consequences, such as market crashes and recessions.

For investors on an individual level, entering the market in the later stages of a bubble could mean painful losses. But misdiagnosing a stock market bubble or exiting from positions too early can result in an investor missing out on potential gains.

The Five Stages of a Market Bubble

Modern-day investors and market observers typically categorize market bubbles based on the principles of Hyman P. Minsky, a 20th century economist whose financial-instability hypothesis became widely cited after the 2008 financial crisis.

Minsky debunked the notion that markets are always efficient. Instead, he posited that underlying forces in the financial system can push actors — such as bankers, investors and traders — toward making bad decisions.

Minsky’s work discussed how bubbles tend to follow a pattern of human behavior. Below is a closer look at the five stages of a bubble cycle:

1. Displacement

Displacement is the phase during which investors get excited about something, typically a new paradigm such as an invention like the Internet, or a change in economic policy, like the cuts to short-term interest rates during the early 2000s by Federal Reserve Chair Alan Greenspan.

2. Boom

That excitement for a new paradigm next leads to a boom. Prices for the new paradigm rise, gradually gathering more momentum and speed as more and more participants enter the market. Media attention also rapidly expands about the new investing trend.

This phase captures the initial price increases of any potential bubble. For instance, after Greenspan cut interest rates in the early 2000s, real-estate prices and new construction of homes boomed. Separately, after the advent of the Internet in the 1990s, shares of technology and dot-com companies began to climb.

3. Euphoria

The boom stage leads to euphoria, which in Minsky’s credit cycle has banks and other commercial lenders extending credit to more dubious borrowers, often creating new financial instruments. In other words, more speculative actions take place as people who are fearful of missing out jump in and fuel the latest craze. This stage is often dubbed as “froth” or as Greenspan called it “irrational exuberance.”

For instance, during the dot com bubble of the late 1990s, companies went public in IPOs even before generating earnings or sales. In 2008, it was the securitization of mortgages that led to bigger systemic risks in the housing market.

4. Profit-Taking

This is the stage in which smart investors or those that are insiders sell stocks. This is the “Minsky Moment,” the point before prices in a bubble collapse even as irrational buying continues.

History books say this took place in 1929, just before the stock market crash that led to the Great Depression. In the decade prior known as the “Roaring 20s,” speculators had made outsized risky bets on the stock market. By 1929, some insiders were said to be selling stocks after shoeshine workers started giving stock tips, which they took to be a sign of overextended exuberance.

5. Panic

Panic is the last stage and has historically occurred when monetary tightening or an external shock cause asset values to start to fall. Some firms or companies that borrowed heavily begin to sell their positions, causing greater price dips in markets.

After the Roaring 20s, tech bubble, and housing bubble of the mid-2000s, the stock market experienced steep downturns in each instance — a period in which panic selling among investors ensued.

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The Takeaway

One of the prevailing beliefs in the financial world is that markets are efficient. This means that asset prices have already accounted for all the information available. But market bubbles show that sometimes actors can discount or misread signs that asset values have become inflated. This typically happens after long stretches of time during which prices have marched higher.

Stock market bubbles may occur when there’s the illusion that share prices can only go higher. While bubbles and boom-and-bust cycles are part of markets, investors should understand that stock volatility is usually inevitable in stock investing.

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FAQ

What is the primary cause of a stock market bubble?

Generally, a stock market bubble is caused by speculative investing and trading, but not always. Increased speculation can cause assets to see their values increase far beyond what might be expected, leading to a bubble.

What are the five stages of a market bubble?

The five stages of a market bubble are displacement, the boom, euphoria, profit-taking, and finally, panic, as the bubble bursts.

Is it easy to recognize a stock market bubble?

While there may be times when an investor believes they see a market bubble forming, they could be wrong. Often, it’s difficult to recognize a market bubble, but it may be important for wary investors to take measures to protect their portfolios as best they can.

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Photo credit: iStock/fizkes

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