What is a stock market bubble?
A stock market bubble is a significant run-up in stock prices without a corresponding increase in the value of the businesses they represent. A company's valuation should be determined by its business fundamentals -- its profits, growth rate, and similar factors. In a bubble, speculation and euphoria take over.
5 stages of a stock market bubble
All stock market bubbles eventually burst, meaning that stock prices suddenly and sharply decline. While any number of events can lead to a bubble bursting, stock market crashes often occur after a key source of credit dries up. A credit contraction was the main reason for the 2008 housing bubble bust, which triggered a global financial crisis.
Economists generally agree that there are five stages of an economic bubble:
- Displacement: This is a paradigm-shifting event. In the case of the housing bubble, this meant lower interest rates (thanks to looser monetary policy from the Federal Reserve Board), easier access to subprime mortgages, new mortgage derivatives from Wall Street, and the fact that U.S. real estate prices had not suffered a sustained, national decline in generations.
- Boom: This is the phase when asset prices begin increasing rapidly. Rising prices attract new investors (or homebuyers, in the case of a housing bubble), but it isn't yet clear that the rise in prices is unwarranted.
- Euphoria: This is the phase were investors tend to make irrational decisions under the assumption that the bubble will continue to inflate. Some people refer to this as the greater fool theory, which is the belief that there will always be someone willing to pay a higher price for an asset than you did. In the case of the housing market, unqualified homeowners were buying homes with the intention of flipping them and making easy money.
- Peak: Prices eventually top out, and the smart money begins to sell. Market sentiment starts to shift. In the housing bubble, this phase was harder to detect since housing prices aren't readily listed like stock prices. But there were signs that defaults were starting to rise and easy credit was going away.
- Collapse: Bubbles tend to leave many retail investors financially ruined, and the housing bubble bust was no different. Home prices fell nationally between 2006 and 2012, leaving homeowners underwater, bankrupt, and with their credit destroyed. Just as prices are overinflated at the peak of the bubble, they tend to be undervalued during the bust.
The reasons for the dot-com bubble burst are slightly more complicated. In this instance, the tech companies' performances didn't match investors' expectations. Many of the dot-com names that went bankrupt had flawed business models that made them incapable of turning a profit. In this bubble, the credit came from venture capitalists and other investors eager to pour money into any business with ".com" in its name. The dot-com companies' growth eventually slowed, profits didn't materialize, and tech stock prices plunged.
Again, Amazon offers a useful example here. In 2000, the Nasdaq Composite Index (NASDAQINDEX:^IXIC) peaked, seemingly because all the new internet companies, Amazon included, had exhausted the initial wave of investor demand. Tech stock prices tumbled as a result. The e-commerce company's revenue growth slowed from 169% in 1999 to just 13% in 2001, tracking with the market's boom and bust. Amazon's stock price declined by more than 90% from peak to trough in just two years.
Market Sentiment
Often the clearest sign of a stock market bubble is market sentiment, or how investors feel about the stock market. J.P. Morgan famously sold his stock holdings ahead of the Great Depression after a shoeshine boy asked him how he could buy stocks. Similarly, there were signs on social media platforms during much of the pandemic boom of euphoric sentiment in the market.
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