It’s common for traders and investors alike to hear warnings of a market bubble whenever the market is aggressively bullish for an extended period. Bubbles occur when investors within a specific sector or across the entire market inflate the value of assets well beyond their realistic worth. While it can be hard to see when a bubble is really happening, bubbles often pop once they get too big – resulting in a sudden market correction or even a crash.
What is a “Bubble”?
There is no specific technical definition for what constitutes a bubble in the stock market. Rather, the term “bubble” is used to describe any situation in which emotional investing has inflated prices beyond the actual value of the underlying assets. This means, for example, that the prices of many stocks across the market are significantly higher than their values based on the underlying companies’ fundamentals.
Bubbles typically occur when savvy investors become increasingly speculative and take on additional risk, while at the same time, less experienced investors get into the market and trade based on emotion and hype. Bubbles can happen around a single stock – for example, after a much-hyped IPO – in a single market sector, or across the entire stock market.
Subjective Nature of Bubbles
Unfortunately for investors, it can be almost impossible to tell if a bubble is happening at any given time. There is no clear way to separate a bubble from a long-term, supported increase in the value of the market or a sector – even if fundamentals would suggest that prices are excessively high.
Instead, bubbles are identified in retrospect, after they pop. Once a bubble pops, and prices come crashing down, it is typically easy for analysts to identify that the previous bullish activity was, in fact, a bubble and to identify the causes.
For example, even though Bitcoin has dropped significantly in value from its 2017 high, it is still unclear whether Bitcoin’s value represents a bubble. Bitcoin may have long-term value, as many of its investors believe, or the value of Bitcoin may be inflated relative to the actual worth of this relatively new currency.
Indications of a Bubble
The first indication that a bubble is happening is hype about a stock, sector, or the market as a whole. This hype is typically driven from the bottom-up by buying pressure, but the hype can take on a life of its own as financial media, and ultimately the mainstream media begin to publicize stories of a meteoric rise in value.
Hype is important to a bubble because it drives the scale of the phenomenon. It would be difficult to create a large bubble with only a handful of traders buying up stocks, but getting everyday investors involved in buying activity can drive extreme valuations across a broader swath of the market.
While hype is a constant part of financial news, traders can keep an eye out for excessive hype around the market. Typically, once non-financial news media is focused on increasing valuations and it becomes a topic of conversation among casual investors, it is likely that the hype itself is widespread enough to contribute to a bubble.
Irrational buying occurs when traders and investors begin deviating from proven, effective strategies. Hype contributes strongly to a rise in irrational buying, as savvy traders and retail investors alike can fall victim to a fear of missing out. This fear, in turn, drives emotional buying that doesn’t take into account broader market conditions. Furthermore, investors may try to justify extreme valuations, as judged by standard measures, to themselves and others by looking at alternative metrics that are inherently riskier.
Traders can avoid irrational buying simply by sticking to their trading strategy and resisting the temptation to chase profits. If valuations are too high relative to fundamentals for the risk management of a particular trading strategy, that should remain true even when others are willing to take greater risks.
Greed is what keeps traders and investors in the market as the bubble expands and encourages them to take even greater risks. As the hype around stocks continues to grow and stories of massive profits circulate, investors consciously or subconsciously believe that they, too, can make increasingly massive profits beyond what they have already gained. This greed, coupled with fear of missing out, pushes investors to make decisions that are highly aggressive and risky rather than to sell and cash out. Thus, investors remain with large holdings in the market even as the size and instability of the bubble increases.
Traders can avoid greed once again by sticking to their trading strategy. Trailing stop losses and specific price targets for each trade can make a significant difference in protecting against excessive profit-chasing and against a market correction.
A Spectrum of Bubbles
Not every bubble needs to be market-wide – bubbles come in a variety of different sizes. Bubbles can occur around a single, specific stock, around a specific type of asset like real estate or currency, or around an entire market sector. Even when it comes to market-wide bubbles, size varies. Bubbles can be extremely large, like the dot-com bubble in the late 1990s, but smaller market-wide bubbles occur frequently. Not all of these bubbles are news-worthy enough to receive extensive coverage in financial and mainstream media, although this lack of coverage and hype also helps to prevent them from becoming larger.
In addition, it can be easy to mistake bubbles for short-term trends and event-driven market activity. Recent examples of bubbles that appeared to many traders to be market trends happened around the 2014 Ebola scare, during which time biotech companies saw a bump in valuations, and the legalization of marijuana in numerous states and in Canada. Bitcoin and other cryptocurrencies are highly subject to bubbles, and bubbles can even form around individual stocks after much-hyped IPOs.
Examples of Bubbles
The dot-com bubble that occurred in the late 1990s is one of the best examples of a recent market bubble. During this time, hype around the Internet combined with a lack of understanding of its potential led venture capitalists to give huge amounts of money to startup tech companies with big ideas but unproven business plans. This hype spilled over to traders and investors as these companies moved rapidly into IPOs, and the size of the bubble only increased thanks to massive media coverage around the growth in technology stocks. During this time, many of the more than 400 technology stocks that came onto the market doubled in value on the day of their IPOs, and several stocks saw annual gains of more than 1,000%.
The bubble grew larger as irrational buying and greed took over. More and more people entered the stock market without having proven trading strategies and without understanding company fundamentals. Even savvy traders became subject to excessive risk-taking as the market continued to grow aggressively.
The dot-com bubble popped in March 2000 as investors began to panic over their exposure to the market and unjustifiable valuations. Over the next two years, the Nasdaq index lost 78% of its value.
Stock market bubbles can be extremely hard to identify when they are happening, but are easy to identify in retrospect. Hype, irrational buying, and greed are all strong signs that a bubble is happening. However, even with those signs, it can be difficult for analysts and traders to tell a bubble from a supported trend, given that bubbles can happen on a variety of different scales and across many different types of market assets.