What is the Stock Market Bubble?

Stock Market Bubble is the phenomena where the prices of the stock of the companies do not reflect the fundamental position of the company and because of this, there is a divide between the real economy and the financial economy caused either due to irrational exuberance of the market participants or due to herd mentality or any other similar reason.In this situation, the stock prices are inflated and can’t be supported by the actual performance of the company and its profits.

Explanation

The prices of securities traded on the stock market get affected by various reasons such as the introduction of a liberal governmental regulation or expansionary measures undertaken by the central bank of the country such as the reduction in the policy rate by the federal reserve. Such measures encourage people to take out money from fixed income instruments and investing the same in the riskier equity market in expectation of higher returns. It is expected that due to such policy changes, the companies would perform better and therefore their shares will rise.

Such expectations may not always be aligned with the actual economic activity that is taking place in the real economy because at times these measures are not able to boost the economy as much as possible. However, such market information is not always complete and therefore the financial markets are not completely efficient. This implies that the prices do not convey all the information that is publicly or privately available.

How Does it Work?

Following are the steps of the eruption and inflation of the stock market bubble:

Above image shows the steps in the bubble formation process, let’s understand it through the example of the dotcom bubble of 1999:

#1 – Disruptive Innovation

Internet technology was a completely new technology that would revamp the way the world functioned. It looked highly promising and therefore a lot of companies entered this domain during the period of 1990-1997, to profit from this prospective new industry.

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#2 – Boom

Several companies saw an initial level of success and the investors started flowing in the money, in hopes of higher returns. This attracted even more companies into this sector who might have not had the capabilities to give a strong performance but were dragged by the booming sector. Further, the tax reforms and cheaper credit availability encouraged these companies to enter this new market. This was the era when Netscape and Yahoo! released their IPOs.

#3 – Irrational Exuberance

At this stage, the investors lose perspective of performance and keep pouring in money without realizing that the companies are not doing their bit and therefore the promising returns might not occur at all. This led to a greater divide between performance and return expectations and inflated the stock prices. This was when NASDAQ quadrupled and the P/E ratios were soaring beyond any limit.

#4 – Profit Booking

When the fed started realizing that they were heading towards a bubble, it started increasing interest rates, and the funding became volatile.
Further, a lot of duplicate companies had emerged and there were talks of mergers among them. Failed mergers led to NASDAQ declining gradually.
Japan, the technology giant, went into another recession.
Investors started realizing that their expectations might not be aligned with the performance, they started selling and booking profits or accepting lower levels of losses so that they may not have to sell their investment at thrift’s price in times to come, this ensued a correction in the market where the stock prices started falling.

#5 – Panic

Globally, the markets started witnessing such incidents and by this stage, several investors saw their wealth eroding and joined the selling spree.
Investors started selling at whichever price possible to exit the sector and save their necks. This was the time when the bubble burst and led to the market crash.
Websites such as Pets.com went out of business and several accounting scandals started emerging such as that of Enron and Satyam.
By this time the technology stocks lost approximately 3/4^th of their value.

Example of the Stock Market Bubble

One of the most popular bubbles in the history of the twentieth century is the crash of Wall Street in 1929 following which the great depression occurred. This was the time when the NYSE stocks crashed leading to erosion of wealth for scores of investors, this crash followed the crash in London Stock Exchange and led to the starting of the Great Depression.
WWI had just ended and there was over-optimism in the population which was migrating to urban areas to find high paying work in the industrial expansion. There was very high speculation which was leading to a divide between the actual product and the speculations about the same, leading to ignoring the fact that steel production, construction activity, auto sales were all slowing down while unemployment was rising.
Bankers gave easy credit that couldn’t be backed by fundamentals. Dow Jones industrial average was still climbing greater heights. These were signals that the bubble had inflated way too much and would burst anytime, which led to investors entering a selling spree, which led to the stocks losing value constantly and finally led to a crash in October 1929.

Causes of the Stock Market Bubble

The following are the causes of the stock market bubble.

#1 – Wild Speculation

This is one of the most important reasons that lead to stock market bubbles because this is the reason why the gorge between the financial and real economy widens. When the market participants are not ready to accept the challenges that the real economy is facing and are still buying the stocks of companies that are underperforming in an expectation that they will gain when these companies do well. It leads to inflation in stock prices and creates a bubble.

#2 – Cheap Credit

When the loans are available at very low-interest rates and the central banks are still on a rate-cutting spree, then it is bound to cause a boom in the non-performing assets in the times to come because the cheap credit is borrowed by even those who don’t have any intention of actually paying it back. Therefore such borrowers are forced to sell assets and this leads to a reduction in production capacity, thereby signaling a weaker economy and so stock prices start falling.

#3 – Panic

When the investors start realizing that the financial economy is about to crash, the panic selling begins, people start booking profits or limiting losses, leading to falling in stock pricing and this initiate the crash in the economy and a time comes when some stocks can’t find buyers at even the lowest low of prices.

#4 – Political Risks

When the geopolitical risks increase and people start feeling unsafe in the country, the stock market initiates dipping and if necessary measures are not taken timely, the crash becomes inevitable.

Consequences of Stock Market Bubble

Crash of Market: As explained above, there comes a time when the bubble inflates beyond the threshold and even a tiny pin poke can burst it, leading to a crash in the market when wealth is eroded completely, stocks lose all their value and economy goes into recessions.
Recession: As the market crashes, it becomes explicit that the economy has not been doing well for a while and therefore, recession sets in the economy, people get laid off, austere measures set in. It becomes impending for the fiscal and monetary policymakers to boost the economy and set the industry back on track.
Widespread Discontent: When the economy doesn’t do well, people’s savings get eaten up, and the future starts looking bleak, people lose hope and motivation leading to instability in the economy.

How to Spot Stock Market Bubble?

Yield curve analysis is a popular tool for analyzing the economic situation. If the short term debt instruments have a higher yield as compared to the long term one, we can say that the economy might be entering into a recession. If such is the case and the stock market is still showing constant increases, then there is a strong chance that the stock market is experiencing a bubble.

The above-explained yield curve is called an inverted yield curve and it implies that the investors are ready to forgo higher interest rates in the future because they want to keep their investments safe and they have no faith that the economy will do well in the future. Therefore the interest rates received on fixed deposits are higher in present times and they will fall because the demand will be higher for such instruments so the cost of these will be higher, and as interest rates and prices are inversely related, the interest rates in the future will be lower.

Conclusion

We can simply say that the market participants need to be aware of the performance of the sector before increasing their investments in any sector and if the divide between financial and real economy is not taken care of in a timely manner, a bubble is inevitable and so is a crash because once the bubble is too large, no monetary or fiscal measures can stop it from bursting.

Stock Market Bubble