A stock market bubble, also known as an asset bubble, occurs when a security or a group of securities trades at an inflated, unsustainable price that cannot be justified by reasonable fundamental analysis of their value. While some might think it has something to do with the moon and stars, there is actually a scientific basis in which stock market bubbles come to play. In this article, we will explore the science of stock market bubbles, how they form and how they burst.

What is Fundamental Analysis?

Fundamental analysis is a method of evaluating the intrinsic value and financial health of a company or financial instrument. By examining the company’s balance sheet, income statement, and other metrics and comparing them with previous periods and industry averages, investors may gain insight into the true value of a company, and thus, be better prepared to make informed decisions about whether to buy or sell.

What Causes a Stock Market Bubble?

So, what causes a stock market bubble? While there is no one definitive answer, there are a number of factors that can contribute to the formation of a bubble. In general, bubbles form due to a combination of investor exuberance, low interest rates, speculation, the herd mentality of investors, and the irrationality of human behavior.

• Investor Exuberance: When investors expect future returns that have no basis in reality, they may buy securities at prices far exceeding their actual value. This can create a “self-fulfilling prophecy” whereby the anticipation of higher prices causes prices to actually increase.

• Low Interest Rates: Low-interest rates, while beneficial to the economy as a whole, may also fuel bubbles, as this environment tends to encourage investors to take greater risks. When borrowing is cheap and stocks look like a better investment than fixed-income securities, investors tend to buy stocks with borrowed money, pushing the prices further up.

• Speculation: At the heart of most bubbles is speculation. Investors buy a security in the hope of selling it for a higher price, rather than because they believe it to be undervalued. Speculation can lead to a “mania” in which prices skyrocket as more and more investors buy in.

• Herd Mentality: This is one of the most powerful forces in the stock market, as it drives investors to make decisions in concert with others. This often leads to buying at the top of the market and selling at the bottom, as investors fear missing out on potential profits and fear potential losses if they don’t follow the crowd.

• Irrationality of Human Behavior: It’s human nature to place greater emphasis on short-term gains than long-term security. This is especially true when one hears stories of others “making a killing” in the stock market, leading many people to jump in without proper research or analysis.

Signs of a Growing Bubble

It’s important to note that bubbles don’t form overnight, despite what many people think. In fact, there are usually telltale signs of a growing bubble, so investors should be aware of them in order to protect their wealth.

• Rapid Expansion: One of the most obvious signs of a potential bubble is a rapid expansion of price and volume. When prices rise quickly on an increase in volume, it signals the possibility of a bubble.

• Valuations: When prices move far ahead of the underlying fundamentals, such as earnings per share, price/earnings ratios, and other measures, it’s a sign of valuation becoming untethered from reality and may signify that a bubble is forming.

• Media Coverage: As prices start to rise, the media often picks up on the story and amplifies it. This may lead more and more investors to jump in, and further fuel the fire.

• Euphoria: As prices continue to rise, investors may become euphoric, disregarding the risks and consequences. As this spreads, more and more investors will join the party, sending prices higher and higher.

Bursting a Bubble

Just like bubbles don’t form overnight, they also don’t suddenly burst. The process of a bubble bursting usually takes a few weeks or months as the underlying fundamentals and reality start to catch up.

• Profit Taking: As the fundamentals start to catch up with prices, investors take note and begin to take profits. This, in turn, leads to a decrease in prices.

• Fear & Panic: As the prices begin to fall, investors become fearful and start to panic sell. This increases the downward price pressure and leads to further decreases in price.

• Contagion: Fear and panic aren’t limited to just the security in question, but may also spread to other securities as well. This creates a contagion effect as more and more investors sell, leading to even further decreases in prices.

• Reversion to the Mean: Eventually, rational market forces kick in and prices start to return to their intrinsic value, as determined by fundamental analysis.

Stock market bubbles form and burst on a regular basis, and understanding the science and the signs of a bubble can help investors protect their wealth. By examining the fundamentals of a security and being aware of the warning signs, investors may be better equipped to spot a bubble in time to get out before it bursts.