You must have heard the saying, “What goes up must come down”? This phrase perfectly encapsulates the volatile nature of the stock market. Throughout history, numerous stock market bubbles were formed, only to inevitably burst, causing widespread panic and financial devastation.
In this blog post, we will explore the causes of stock market bubbles and the crashes that follow them.
What Is a Stock Market Bubble?
A bubble, in economic context (also known as a speculative or financial bubble), occurs when the current prices of assets significantly surpass their intrinsic valuation, which is the value that can be justified by the underlying long-term fundamentals.
Economic bubbles can arise from overly optimistic projections regarding growth sustainability or a belief that intrinsic valuation is no longer applicable to investments.
Types Of Bubbles
Asset Market Bubble: An asset market bubble refers to a swift rise in the price of any asset class other than equities, such as real estate, that results from speculative buying and irrational excitement amongst buyers. Examples of asset market bubbles include the rapid appreciation of cryptocurrencies and the US housing bubble that peaked in 2006.
Stock Market Bubble: When equities or stocks show a rapid rise in their price without any change in the company’s underlying fundamentals, it is called a stock market bubble.
Commodity Bubble: When commodities show rapid rise in price without any underlying change in their usage or production, it is called a commodity market bubble. Commodities like gold, silver, crude oil etc, may show such behaviour.
Credit Bubble: A credit bubble happens when there is significant growth in retail or corporate loans or any other form of credit in the economy that the borrowers cannot repay. A credit bubble affects almost all the sectors of an economy and has the potential to bring recession.
Now that we have understood the different types of bubbles that can happen in an economy, let us focus on this blog’s main topic and discuss the stock market bubble in detail.
What Causes The Stock Market Bubble?
Stock market bubbles can happen due to various complex reasons. Some of the reasons why stock market bubbles have occurred in the past are as follows:
Speculative buying: When investors become overly optimistic about the future prospects of a particular company or industry, they may engage in speculative buying, driving up stock prices beyond their intrinsic value.
Low-interest rates: Low-interest rates make borrowing money cheap and can encourage investors to take more risks by investing in stocks which can push their prices.
Excess liquidity: If abundant money exists in the financial system, investors may seek higher returns by investing it in the stock market, leading to a surge in demand and prices.
Overvalued companies: Companies may become overvalued due to irrational excitement about their growth, leading to inflated stock prices that do not reflect their financial performance.
Market psychology: When investors believe that stock prices will continue to rise indefinitely, they may engage in manic buying, leading to a bubble that eventually bursts.
5 Stages Of Stock Market Bubble
A stock market bubble follows 5 stages
The bubble begins with a shift in investors’ beliefs or a change in technology that leads to an increase in stock performance expectations.
Rapid price growth occurs as investors speculate about the stock’s potential and spread the word to others. The stocks gain popularity and attract numerous investors.
As stock prices overgrow, investors fear missing out on potential gains and buy stocks without any fundamental justification. Stock prices reach their peak during this stage, and investors believe that someone will always pay more for their stocks.
Some investors see this as a signal to exit their positions and reap profits.
As the bubble reaches its limit, investors begin to realize that they may face losses if they hold onto their stocks. Panic selling ensues, leading to declining prices and the eventual bursting of the bubble.
What Happens When A Bubble Bursts?
The demand for stocks declines when the stock market bubble bursts, causing a rapid fall in prices. The rate of decline can exceed the previous rate of growth. The bursting of the bubble typically leads to erosion of investors’ profits and is often followed by a stock market crash.
What Is A Stock Market Crash?
A stock market crash is a situation when a significant number of stocks and benchmark indexes experience a drastic decline. Panic selling is often the cause of such crashes, and further panic selling in response to the crash can worsen the collapse.
What Causes A Stock Market Crash?
The stock market crash can be triggered by various factors, such as the bursting of a stock market bubble, natural disasters, political instability, economic crisis, higher inflation rates, among others.
In recent times there are few examples when stock markets crashed due to such situations
- Demonetisation of ₹500 and ₹1000 notes in 2016.
- When Covid-19 pandemic caused lockdown in India.
Stock market bubbles and crashes are significant events that can have a profound impact on investors, traders, and the economy as a whole. A bubble’s rise and eventual burst can result in a market crash, causing substantial financial losses. Although various factors can trigger such events, informed decision-making can help mitigate risks and potentially benefit from market volatility.
As always, it’s crucial to stay updated with the latest trends and news in the stock market and make well-informed decisions based on careful analysis and research.
A stock market bubble refers to a situation where stock prices experience a rapid and unsustainable increase, far exceeding their intrinsic value based on underlying fundamentals.
There are several types of economic bubbles: asset market bubbles, stock market bubbles, commodity bubbles, and credit bubbles. Each involves rapid price increases in various asset classes.
Stock market bubbles can arise due to factors such as speculative buying, low-interest rates, excess liquidity in the financial system, overvaluation of companies, and market psychology where investors believe prices will keep rising indefinitely.
A stock market bubble typically progresses through five stages: Displacement, Boom, Euphoria, Profit-taking, and Panic. These stages represent shifts in investor behavior and market sentiment.
When a stock market bubble bursts, demand for stocks decreases rapidly, leading to a sharp decline in prices. This decline can be more severe than the previous growth, causing financial losses for investors.