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Ready to Burst: What to Know About Market Bubbles

Score Priority Team
Posted by Score Priority Team on Jan 19, 2021 8:15:00 AM

Do these record highs mean the market is in a bubble? Here’s what we know about this economic movement.

 

All good things tend to come to an end — or in the case of a market bubble, what floats up must come down. 

Some financial experts are suspicious of how long the stock market highs of the past few months will last. After the dramatic market losses in March 2020, many U.S. stock market indexes have sustained or surpassed records. Because of these highs, some analysts have claimed the market is currently experiencing a bubble.

No matter how much soap you put in your bubble wand, eventually every bubble must pop. In the stock market, however, determining when a bubble will pop is difficult. In fact, defining a bubble while in the midst of one is not an exact science. Even when reviewing past speculative bubbles in history, using the data to evaluate present-day performance is tricky due to the inconsistent circumstances of each case. 

 

BUBBLE TROUBLE

A market bubble happens when asset prices are noticeably higher than the value of those assets. Those overrated prices create an acceleration in market value, and eventually, those inflated prices are followed by a rapid decrease, indicating the bubble has “burst.”

Put simply, a bubble tends to represent hype. Expectations from investors surpass any measurable quality of a company’s business fundamentals, such as profits or a sound business model.

Financial bubbles date back to “tulip mania” in Holland in 1634, which is when the price of tulips snowballed to outrageous highs, according to FINRA's Investor Insights page. More recent examples of bubbles in the U.S. have been less about an individual good and more about the complicated structures that affect certain industries.

  • Roaring 20s: When the Federal Reserve eased credit requirements and lowered interest rates in the early 1920s, consumers and businesses took on excessive debt and stock prices soared. In 1929, margin requirements were only 10 percent, and the unchecked post-war optimism gave investors the confidence to borrow capital for stocks. When too many investors became over-leveraged, the speculative bubble popped, and investors couldn’t pay their debts. 
  • Dotcom Bubble: Investors in the late 1990s were right when they predicted the growth and future importance of the internet. However, their eagerness to be part of this movement overshadowed a critical understanding of the companies in which they invested. Many investors sank their money into any internet-based startup with a “.com” in the company’s name — whether or not that company had any sound business fundamentals. 
  • Housing Bubble: Low interest rates, predatory private mortgage lending, and lax regulation contributed to an unsustainable growth of home prices. Lenders extended home loans to unfit borrowers with bad credit histories, meaning many people took on loans that they couldn’t afford. 

 

BALLOONING GROWTH

Determining the scope of a financial bubble can be difficult, but economists often identify a financial bubble with five stages.

  1. Displacement: A new product, technology, or situation (such as low interest rates) grabs the attention of investors. 
  2. Boom: After a displacement, prices for the asset gain momentum due to increased media attention and interest from investors. FOMO (Fear of Missing Out) often motivates investors during this phase.
  3. Euphoria: Prices balloon as investors indiscriminately commit to the trending product or technology. Some investors rely on the greater fool theory — the idea that you can always sell an overpriced security to a more gullible investor — to justify more purchases.
  4. Profit-taking: When some investors grow wary of the euphoria phase, they may begin to sell in anticipation of an incoming crash.
  5. Panic: Prices plummet, often as quickly as they rose. In the rush to offload their securities, investors aim to sell at any price and supply overwhelms the demand.

 

ARE WE IN A BUBBLE RIGHT NOW?

Not all bubbles look the same. Some financial analysts may distinguish these phenomena as an irrational or a rational bubble. Irrational exuberance means investors rely on emotional and psychological factors instead of fundamental values. On the other hand, investors in a rationally-growing bubble are aware that the assets may be overvalued, but they will keep investing because they anticipate prices will continue to increase.

Unfortunately, the only reliable way to define a bubble is after it has already popped. Predicting exactly when the bubble will burst is nearly impossible, especially because there are multiple factors that can affect it. 

For example, while dotcom investors saw promise in the growth of the internet, many of them didn’t anticipate the elements that would determine an internet-based company’s value. Since the idea of dotcom startups was so new at the time, many investors neglected those unique considerations, such as the availability of fiber optic cables or the estimated shipping costs from online deliveries. While we can be critical of the hype generated during the dotcom bubble, anticipating the novel circumstances of the early 2000s is easier to do in 2021.

If we had a dollar for every time someone called the COVID-19 crisis “unprecedented,” our pocketbooks would match the record-breaking stock market. Because of this unconventional situation, estimating whether we are in a bubble — and if so, when the bubble may burst — is futile. 

Instead, investors can determine their strategy based on the amount of risk they can tolerate. Researching each investment, developing a trading plan, and setting up a defensive strategy may help mitigate risk during the stock market’s surprising moments.

The markets can be an exciting challenge; that's why Score Priority has the tools to help you know the score. Please feel free to visit our website to learn more.

Topics: investing, bubble, market bubble, speculative bubble