Stock market bubble
Encyclopedia
A stock market bubble is a type of economic bubble
taking place in stock market
s when market participants drive stock
prices above their value in relation to some system of stock valuation
.
Behavioral finance
theory attributes stock market bubbles to cognitive biases that lead to groupthink
and herd behavior
. Bubbles occur not only in real-world markets, with their inherent uncertainty and noise, but also in highly predictable experimental markets. In the laboratory, uncertainty is eliminated and calculating the expected returns should be a simple mathematical exercise, because participants are endowed with assets that are defined to have a finite lifespan and a known probability distribution of dividends.
Other theoretical explanations of stock market bubbles have suggested that they are rational, intrinsic, and contagious.
in France and the South Sea bubble in England. Both bubbles came to an abrupt end in 1720, bankrupting thousands of unfortunate investors. Those stories, and many others, are recounted in Charles Mackay
's 1841 popular account, "Extraordinary Popular Delusions and the Madness of Crowds
".
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The two most famous bubbles of the twentieth century, the bubble in American stocks in the 1920s just before the Great Depression
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 Encilhamento
occurred in Brazil during late 1880s and early 1890s, the Nifty Fifty
stocks in the early 1970s, Taiwanese
stocks in 1987 and Japanese stocks in the late 1980s.
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 misallocate investment funds to areas dictated by speculative trends, rather than to enterprises generating longstanding economic value. Typically when there is an over abundance of IPOs in a bubble market, a large portion of the IPO companies fail completely, never achieve what is promised to the investors, or can even be vehicles for fraud.
) seem to be the causes of 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. Large traders become powerful enough to rock the boat, generate stock market bubbles.
To sort out the competing claims between behavioral finance and efficient markets theorists, observers need to find bubbles that occur when a readily-available measure of fundamental value is also observable. The bubble in closed-end country funds in the late 1980s is instructive here, as are the bubbles that occur in experimental asset markets. For closed-end country funds, observers can compare the stock prices to the net asset value per share (the net value of the fund's total holdings divided by the number of shares outstanding). For experimental asset markets, observers can compare the stock prices to the expected returns from holding the stock (which the experimenter determines and communicates to the traders).
In both instances, closed-end country funds and experimental markets, stock prices clearly diverge from fundamental values. Nobel laureate Dr. Vernon Smith
has illustrated the closed-end country fund phenomenon with a chart showing prices and net asset values of the Spain Fund in 1989 and 1990 in his work on price bubbles. At its peak, the Spain Fund traded near $35, nearly triple its Net Asset Value of about $12 per share. At the same time the Spain Fund and other closed-end country funds were trading at very substantial premiums, the number of closed-end country funds available exploded thanks to many issuers creating new country funds and selling the IPOs at high premiums.
It only took a few months for the premiums in closed-end country funds to fade back to the more typical discounts at which closed-end funds trade. Those who had bought them at premiums had run out of "greater fools". For a while, though, the supply of "greater fools" had been outstanding.
loop.
Like all dynamic systems, financial markets operate in an ever changing equilibrium, which translates into price volatility
. However, a self-adjustment (negative feedback
) takes place normally: when prices rise more people are encouraged to sell, while fewer are encouraged to buy. This puts a limit on volatility. However, once positive feedback takes over, the market, like all systems with positive feedback, enters a state of increasing disequilibrium
. This can be seen in financial bubbles where asset prices rapidly spike upwards far beyond what could be considered the rational "economic value", only to fall rapidly afterwards.
managers, are compensated and retained in part due to their performance relative to peers. Taking a conservative or contrarian position as a bubble builds results in performance unfavorable to peers. This may cause customers to go elsewhere and can affect the investment manager's own employment or compensation. The typical short-term focus of U.S. equity markets exacerbates the risk for investment managers that do not participate during the building phase of a bubble, particularly one that builds over a longer period of time. In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the risks of not doing so outweigh the benefits.
Specific:
Economic bubble
An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...
taking place in stock market
Stock market
A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...
s when market participants drive stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
prices above their value in relation to some system of stock valuation
Stock valuation
In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally potential market prices, and thus to profit from price movement – stocks that are judged...
.
Behavioral finance
Behavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...
theory attributes stock market bubbles to cognitive biases that lead to groupthink
Groupthink
Groupthink is a psychological phenomenon that occurs within groups of people. It is the mode of thinking that happens when the desire for harmony in a decision-making group overrides a realistic appraisal of alternatives. Group members try to minimize conflict and reach a consensus decision without...
and herd behavior
Herd behavior
Herd behavior describes how individuals in a group can act together without planned direction. The term pertains to the behavior of animals in herds, flocks and schools, and to human conduct during activities such as stock market bubbles and crashes, street demonstrations, sporting events,...
. Bubbles occur not only in real-world markets, with their inherent uncertainty and noise, but also in highly predictable experimental markets. In the laboratory, uncertainty is eliminated and calculating the expected returns should be a simple mathematical exercise, because participants are endowed with assets that are defined to have a finite lifespan and a known probability distribution of dividends.
Other theoretical explanations of stock market bubbles have suggested that they are rational, intrinsic, and contagious.
Examples
Two famous early stock market bubbles were the Mississippi SchemeMississippi Company
The "Mississippi Company" became the "Company of the West" and expanded as the "Company of the Indies" .-The Banque Royale:...
in France and the South Sea bubble in England. Both bubbles came to an abrupt end in 1720, bankrupting thousands of unfortunate investors. Those stories, and many others, are recounted in Charles Mackay
Charles Mackay
Charles Mackay was a Scottish poet, journalist, and song writer.-Life:Charles Mackay was born in Perth, Scotland. His father was by turns a naval officer and a foot soldier; his mother died shortly after his birth. Charles was educated at the Caledonian Asylum, London, and at Brussels, but spent...
's 1841 popular account, "Extraordinary Popular Delusions and the Madness of Crowds
Extraordinary Popular Delusions and the Madness of Crowds
Extraordinary Popular Delusions and the Madness of Crowds is a history of popular folly by Scottish journalist Charles Mackay, first published in 1841. The book chronicles its subjects in three parts: "National Delusions", "Peculiar Follies", and "Philosophical Delusions"...
".
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
and the Dot-com bubble
Dot-com bubble
The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
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
Radio
Radio is the transmission of signals through free space by modulation of electromagnetic waves with frequencies below those of visible light. Electromagnetic radiation travels by means of oscillating electromagnetic fields that pass through the air and the vacuum of space...
, automobiles, aviation
Aviation
Aviation is the design, development, production, operation, and use of aircraft, especially heavier-than-air aircraft. Aviation is derived from avis, the Latin word for bird.-History:...
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 Encilhamento
Encilhamento
The Encilhamento was a economic bubble that boomed between late 1880s and early 1890s in Brazil, having burst during the provisional government of Deodoro da Fonseca , then becoming a financial crisis...
occurred in Brazil during late 1880s and early 1890s, the Nifty Fifty
Nifty Fifty
Nifty Fifty was an informal term used to refer to 50 popular large cap stocks on the New York Stock Exchange in the 1960s and 1970s that were widely regarded as solid buy and hold growth stocks....
stocks in the early 1970s, Taiwanese
Economy of Taiwan
Taiwan has a developed capitalist economy that ranks as the 19th largest in the world by Purchasing power parity and 24th in nominal GDP of investment and foreign trade by the Republic of China government which governs Taiwan. In keeping with this trend, most large government-owned banks and...
stocks in 1987 and Japanese stocks in the late 1980s.
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 misallocate investment funds to areas dictated by speculative trends, rather than to enterprises generating longstanding economic value. Typically when there is an over abundance of IPOs in a bubble market, a large portion of the IPO companies fail completely, never achieve what is promised to the investors, or can even be vehicles for fraud.
Whether rational or irrational
Emotional and cognitive biases (see behavioral financeBehavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...
) seem to be the causes of 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
New Economy
The New Economy is a term to describe the result of the transition from a manufacturing-based economy to a service-based economy. This particular use of the term was popular during the Dot-com bubble of the late 1990s...
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
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...
of fundamental returns. Large traders become powerful enough to rock the boat, generate stock market bubbles.
To sort out the competing claims between behavioral finance and efficient markets theorists, observers need to find bubbles that occur when a readily-available measure of fundamental value is also observable. The bubble in closed-end country funds in the late 1980s is instructive here, as are the bubbles that occur in experimental asset markets. For closed-end country funds, observers can compare the stock prices to the net asset value per share (the net value of the fund's total holdings divided by the number of shares outstanding). For experimental asset markets, observers can compare the stock prices to the expected returns from holding the stock (which the experimenter determines and communicates to the traders).
In both instances, closed-end country funds and experimental markets, stock prices clearly diverge from fundamental values. Nobel laureate Dr. Vernon Smith
Vernon L. Smith
Vernon Lomax Smith is professor of economics at Chapman University's Argyros School of Business and Economics and School of Law in Orange, California, a research scholar at George Mason University Interdisciplinary Center for Economic Science, and a Fellow of the Mercatus Center, all in Arlington,...
has illustrated the closed-end country fund phenomenon with a chart showing prices and net asset values of the Spain Fund in 1989 and 1990 in his work on price bubbles. At its peak, the Spain Fund traded near $35, nearly triple its Net Asset Value of about $12 per share. At the same time the Spain Fund and other closed-end country funds were trading at very substantial premiums, the number of closed-end country funds available exploded thanks to many issuers creating new country funds and selling the IPOs at high premiums.
It only took a few months for the premiums in closed-end country funds to fade back to the more typical discounts at which closed-end funds trade. Those who had bought them at premiums had run out of "greater fools". For a while, though, the supply of "greater fools" had been outstanding.
Positive feedback
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 a positive feedbackPositive feedback
Positive feedback is a process in which the effects of a small disturbance on a system include an increase in the magnitude of the perturbation. That is, A produces more of B which in turn produces more of A. In contrast, a system that responds to a perturbation in a way that reduces its effect is...
loop.
Like all dynamic systems, financial markets operate in an ever changing equilibrium, which translates into price volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
. However, a self-adjustment (negative feedback
Negative feedback
Negative feedback occurs when the output of a system acts to oppose changes to the input of the system, with the result that the changes are attenuated. If the overall feedback of the system is negative, then the system will tend to be stable.- Overview :...
) takes place normally: when prices rise more people are encouraged to sell, while fewer are encouraged to buy. This puts a limit on volatility. However, once positive feedback takes over, the market, like all systems with positive feedback, enters a state of increasing disequilibrium
Disequilibrium
Disequilibrium is a term used to describe the lack of or opposite of an equilibrium.* in medicine:** Disequilibrium in cerebral palsy - a syndrome described by Hagberg & all** lack of equilibrioception...
. This can be seen in financial bubbles where asset prices rapidly spike upwards far beyond what could be considered the rational "economic value", only to fall rapidly afterwards.
Effect of incentives
Investment managers, such as stock mutual fundMutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
managers, are compensated and retained in part due to their performance relative to peers. Taking a conservative or contrarian position as a bubble builds results in performance unfavorable to peers. This may cause customers to go elsewhere and can affect the investment manager's own employment or compensation. The typical short-term focus of U.S. equity markets exacerbates the risk for investment managers that do not participate during the building phase of a bubble, particularly one that builds over a longer period of time. In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the risks of not doing so outweigh the benefits.
See also
- Business cycleBusiness cycleThe term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
- Collective behaviorCollective behaviorThe expression collective behaviour was first used by Robert E. Park, and employed definitively by Herbert Blumer, to refer to social processes and events which do not reflect existing social structure , but which emerge in a "spontaneous" way.Collective behavior might also be defined as action...
- DiversificationDiversification (finance)In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of...
- Dot-com bubbleDot-com bubbleThe dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
- Fictitious capitalFictitious capitalFictitious capital is a concept used by Karl Marx in his critique of political economy. It is introduced in chapter 29 of the third volume of Capital. Fictitious capital contrasts with what Marx calls "real capital" which is capital actually invested in physical means of production and workers, and...
- Irrational exuberance
- Market trendMarket trendA market trend is a putative tendency of a financial market to move in a particular direction over time. These trends are classified as secular for long time frames, primary for medium time frames, and secondary for short time frames...
- Modeling and analysis of financial markets
- Ponzi schemePonzi schemeA Ponzi scheme is a fraudulent investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from any actual profit earned by the individual or organization running the operation...
- Pyramid schemePyramid schemeA pyramid scheme is a non-sustainable business model that involves promising participants payment or services, primarily for enrolling other people into the scheme, rather than supplying any real investment or sale of products or services to the public...
- Stock market crashStock market crashA stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors...
Specific:
- Mississippi CompanyMississippi CompanyThe "Mississippi Company" became the "Company of the West" and expanded as the "Company of the Indies" .-The Banque Royale:...
- Poseidon bubblePoseidon bubbleThe Poseidon bubble was a stock market bubble in which the price of Australian mining shares soared in late 1969, then crashed in early 1970. It was triggered by the Poseidon NL company's discovery of a promising site for nickel mining in September 1969....
- Railway ManiaRailway ManiaThe Railway Mania was an instance of speculative frenzy in Britain in the 1840s. It followed a common pattern: as the price of railway shares increased, more and more money was poured in by speculators, until the inevitable collapse...
- South Sea Company
- Tulip maniaTulip maniaTulip mania or tulipomania was a period in the Dutch Golden Age during which contract prices for bulbs of the recently introduced tulip reached extraordinarily high levels and then suddenly collapsed...
External links
- Accounts of the South Sea Bubble, John LawJohn Law (economist)John Law was a Scottish economist who believed that money was only a means of exchange that did not constitute wealth in itself and that national wealth depended on trade...
and the Mississippi CompanyMississippi CompanyThe "Mississippi Company" became the "Company of the West" and expanded as the "Company of the Indies" .-The Banque Royale:...
can be found in Charles MackayCharles MackayCharles Mackay was a Scottish poet, journalist, and song writer.-Life:Charles Mackay was born in Perth, Scotland. His father was by turns a naval officer and a foot soldier; his mother died shortly after his birth. Charles was educated at the Caledonian Asylum, London, and at Brussels, but spent...
's classic Extraordinary Popular Delusions and the Madness of CrowdsExtraordinary Popular Delusions and the Madness of CrowdsExtraordinary Popular Delusions and the Madness of Crowds is a history of popular folly by Scottish journalist Charles Mackay, first published in 1841. The book chronicles its subjects in three parts: "National Delusions", "Peculiar Follies", and "Philosophical Delusions"...
(1843) - available from Project Gutenberg. Warning: this reference has been widely criticized by historians. - the compelling Real DJIA, 1924-now
- the 3 Fed Chair warnings, Real DJIA