What are Market Bubbles?

Published on Feb 8, 2022

What is a Bubble?

A stock market bubble occurs when stock prices rise significantly, surpassing and accelerating above and beyond their fundamental value. This continues till they hit a brick wall, falling fast and hard, causing the bubble to pop. Only then can bubbles be identified.

How do Bubbles Happen?

Bubbles happen when people are willing to pay more for stocks than their fundamental value, which can be calculated using stocks’ growth, demand, earnings, and other indicators. At this stage, investors become anxious to buy in the hope of profiting from the market boom. But then prices rise, even more, creating scarcity that consequently leads to a sharp fall. These stocks are considered overvalued and are proven to be so when they eventually drop sharply. The overvalue of a share equals the bubble, which can be derived from the difference between the trading price and fundamental value.

Stages of a Stock Market Bubble

Displacement: This happens when investors face a substantial paradigm shift in the economic environment (ultra-low interest rates, new tech, and new investment opportunities.)

Boom: This is when prices start gaining momentum and acceleration, attracting media attention which causes the fear of missing out (FOMO) to spread, and more investors enter the boom phase.

Euphoria: Valuations go through the roof, while markets start becoming resilient to corrections and sell-offs as more buyers keep entering the stock market.

Profit-Taking: This is where investors start to reap the fruit of their investments.

Panic: A minor event occurs in markets, causing a drop in prices, and the ensuing fear drives market participants to liquidate their positions to avoid losses and margin calls. Everyone starts selling, and prices begin to nosedive.

History of Market Bubbles

Tulipmania is the mother of all bubbles. It occurred after a surge in tulip prices swamped the Dutch markets in the 1630s, reaching highs far beyond their value. A couple of months later, the prices crashed big, valuing only a fraction of their peak levels.

Dot-com Bubble developed through the late 1990s when many  Internet companies filed for Initial Public Offerings (IPOs) and their endless futuristic promises. The dot-com bubble drove the S&P 500 to double in value in terms of a few years. Yet, most of these companies ended up collapsing and taking the stock market along with them.

The 2008 U.S. Housing Bubble started to form in the mid-2000s amidst souring U.S. home prices that rose as high as 80%. Still, people who could not afford to buy a house were investing in the housing market left and right, escalating the crisis even more. This ended with a collapse of the American housing market and the entire global economy.

Is the Market in a Bubble?

An economic downturn accurately describes global markets since early 2020 and COVID-19 lockdown. The fear of an economic “overheating,” similar to what preceded the bursting of both the dot-com and housing bubbles, drove governments and central banks to take extensive measures to cool down inflation and prevent a disaster. But would that be enough?

There is no clear answer, but what we know for sure is that bubbles are inherently irrational and can be very unpredictable. Even so, economists believe that we have already witnessed several asset bubbles bursting in the last 12 months, such as GameStop, AMC, and Dogecoin. They further view Tesla’s and Bitcoin’s stock prices as overvalued, which will soon burst and head downwards as part of larger tech, crypto, and overall market bubbles. 

Why would the Bubble Burst in 2022?

A current bubble might burst in 2022 as raising funds and interest rates might not do it against the skyrocketing inflation. In addition, there are many signs of bubbles across the market when investors are being extremely bullish. Meaning people are not trading in a fashion that exhibits caution from a potential recession.

What we can advise people to do during uncertain times is to follow the wisdom of the Oracle of Omaha: “Be fearful when others are greedy and greedy when others are fearful.”