What is a stock market bubble?

A stock market bubble is a type of economic bubble taking place in stock markets when price of stocks rise and become overvalued by any measure of stock valuation. The rise in prices is completely irrational and is not based on any fundamentals of company performance or profitability.

Why do stock market bubbles form?

The existence of stock market bubbles is at odds with the assumptions of efficient market theory which assumes rational investor behavior. Behavioral finance theory attribute stock market bubbles to cognitive biases that lead to groupthink and herd behavior. Other theoretical explanations of stock market bubbles have suggested that they are rational, intrinsic, and contagious.

A rational or irrational phenomenon?

Emotional and cognitive biases seem to be the causes of stock market 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.

Examples of stock market bubbles:

Two famous early stock market bubbles were the Mississippi Scheme in France and the South Sea bubble in England. Both bubbles came to an abrupt end in 1720 bankrupting thousands of unfortunate investors.

The two most famous bubbles of the twentieth century, the bubble in American stocks in the 1920s and the Dot-com bubble of the late 1990s were based on speculative activity surrounding the development of new technologies.

The 1920s saw the widespread introduction of an amazing range of technological innovations including radio, automobiles, aviation and the deployment of electrical power grids. The 1990s was the decade when Internet and e-commerce technologies emerged.

Other stock market bubbles of note include the Nifty Fifty stocks in the early 1970s, Taiwanese stocks in 1987 and Japanese stocks in the late 1980s.

Effect of bubbles on IPO’s:

Stock market bubbles frequently produce hot markets in Initial Public Offerings, since investment bankers and their clients see opportunities to float new stock issues at inflated prices. These hot IPO markets mis allocate investment funds to areas dictated by speculative trends, rather than to enterprises generating longstanding economic value.

Catch 22:

A rising price on any share will attract the attention of investors. Not all of those investors are willing or interested in studying the intrinsics of the share and for such people the rising price itself is reason enough to invest. In turn, the additional investment will provide buoyancy to the price, thus completing the loop.