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Market bubble history and how do they work?

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Market bubbles have existed for ages, often leading to serious economic issues. They occur when prices of assets like stocks or real estate shoot up quickly, fueled more by excitement than real economic growth. Eventually, these bubbles burst, causing prices to drop drastically and hurting investors. Imagine everyone believing the market will keep rising, riding the wave of success. Then, without warning, the market crashes, wiping out investments and leaving people broke. This happens when a bubble bursts—too much faith leads to financial disaster.

Here are a few examples: the Tulip Mania in the 1600s, the Dot-com bubble in the 1990s, and the recent housing market crash. Prices soared beyond reason and came crashing down for all of these. The stock market bubble, in particular, has experienced several crashes, as investors often become overly enthusiastic about popular trends, only to confront difficult corrections when the bubble eventually bursts.

Nevertheless, what is a market bubble, how do they form, and why do they burst? In this blog, we’ll explore the fascinating history of market bubbles, including the stock market bubbles, and understand the key factors that drive them, helping you recognize how to spot the warning signs before you get into the trap.

The stock market bubbles have had their share of crashes, and investors are faced with grim truths by being over-enthusiastic about fads. While it is regarded that all economic bubbles eventually burst, every bubble does not burst in the same manner or at the same time. An example of bubbles eventually bursting and their timings may be of some relevance:

BubblePeak PeriodBurst PeriodCharacteristicsImpact
Dot-Com BubbleMarch 20002000- 2002Fueled by speculation in tech stocks and internet adoptionNASDAQ dropped nearly 78%, a recovery for some companies like Amazon.
Housing BubbleMid-20062007- 2008Driven by subprime mortgages and speculative home buyingThis led to the 2008 financial crisis with lasting global economic effects.

What is a market bubble?

A bubble is a phase in the economy where the prices of assets, like stocks, real estate, or commodities, surge rapidly, often beyond their true value. This rapid price increase is typically driven by speculative buying, where investors expect prices to keep rising and rush to buy assets. 

However, this growth is unsustainable, and at some point, the bubble reaches its peak. Once prices stop increasing or external factors trigger a change, panic sets in, and investors start selling off their assets. This leads to a sharp decline in prices, referred to as a “crash” or “bubble burst.” The aftermath of such an event can cause significant financial losses and even broader economic downturns as confidence in the market erodes. Bubbles are often fueled by excessive optimism and are disconnected from the actual fundamentals of the assets involved.

What are the types of market or economic bubbles?

Some of the different types of economic bubbles are:

  • Stock market bubbles: This type of equity market bubble occurs when stock prices rise unjustifiable, often motivated by rumors and eagerness about a specific industry or company. 
  • Housing bubbles: They occur when real estate prices rise to unmanageable levels due to access to credit and speculation about future price increases.
  • Commodity bubbles occur when the prices of commodities, such as oil or gold, rise to unmanageable levels. Supply shortages, speculation, and geopolitical events are some of the causes.  

What is the history of stock bubbles?

The concept of speculation driving prices to unrealistic heights, only for them to come crashing down, isn’t new. It all started with the birth of the first official stock exchange in the Dutch Republic in the 17th century. This period also led to the world’s first recorded speculative bubble, Tulip Mania, one of the famous investing bubbles

In the 1630s, tulips became a status symbol in Holland. They were highly prized for their vibrant colors and exotic appeal. Dutch collectors created a hierarchy of tulip varieties, assigning values based on species and coloring. As demand for tulips grew, so did the prices, with even middle-class families investing heavily in tulip bulbs. By 1636, people were mortgaging homes to buy these bulbs, hoping to sell them for a higher price. However, in February 1637, the bubble burst. The market crashed, leaving many with tulip bulbs they couldn’t sell. Tulip prices plummeted, and the financial fallout led to lawsuits. In 1638, the government allowed buyers to cancel contracts at a fraction of the price they initially agreed upon. 

A century later, in 1719, France experienced the Mississippi Bubble. Following years of financial instability, a Scotsman named John Law introduced paper currency and established the Mississippi Company, which promised huge profits from trade with French colonies. Law also took on France’s national debt, offering shares in the company to investors. The demand for shares soared, but by May 1720, the bubble burst as the government revealed that the country’s metallic currency reserves were insufficient to back the paper money. The company’s shares became worthless, and Law fled France.

Around the same time, England saw the South Sea Bubble. The South Sea Company promised enormous trade profits and managed government debt. In 1720, speculators drove up share prices, but by August, the bubble burst, wiping out fortunes. This event led to investigations and imprisonment of those involved in the scheme

Modern Stock Market Bubbles of the 1900s:

The history of market bubbles set the stage for the detailed concept of stock bubbles. As the twentieth century began, the introduction of varied new technologies took the market by storm, which was later followed by the advent of the internet and e-commerce trends in the late 1900s. During these times, three of the most famous stock bubbles occurred- 

The Wall Street Crash of 1929: 

This stock market bubble in the United States boomed in the 1920s.  The late 1920s U.S. stock market was supported by policies like free trade, corporate advancements, and the Federal Reserve’s establishment in 1913. However, the real driver behind the market’s rise—and eventual collapse—was the growing use of leverage. 

Americans increasingly used credit to buy new products like cars and radios and invest in stocks. By 1929, stock prices soared, especially in tech-driven industries like radio and automobiles. On 3rd September 1929, the Dow peaked, but panic soon hit. “Black Thursday” on Oct. 24 triggered a sell-off, followed by record drops on “Black Monday” and “Black Tuesday.” Despite brief rallies, the market spiraled into the early 1930s, marking the infamous Crash of 1929. 

The Japanese Economic Bubble (1984-1989): 

Financial deregulation in the 1970s allowed banks to expand aggressively, and by the mid-1980s, Japan had adopted loose monetary policies. This led to an increased money supply, low interest rates, and easier credit access, fueling a speculative bubble.

The bubble was largely driven by “zaitech,” a form of financial engineering in which companies used low-interest loans to invest in speculative activities. Many corporations reported speculative gains as part of their earnings, attracting more investors and driving stock prices higher. By the late 1980s, about 50% of profits for some of Japan’s largest companies came from these speculative practices.

Land speculation also surged as property was often used as collateral for loans. The high value of land added to the bubble, with property prices soaring. Concerned, the Japanese government tightened monetary policy in 1989 by raising interest rates. Though the Nikkei hit an all-time high in December 1989, the market crashed soon after, leading to a prolonged period of slow growth throughout the 1990s

The Dot-com Bubble: 

The dot-com bubble, which lasted from 1995 to 2001, saw internet-related tech companies draw immense attention from venture capitalists and investors. The internet’s growing popularity and easy access to financing due to low interest rates soared tech valuations. Many companies had little or no profit, but their stock prices soared despite that. By late 2000, the flow of easy money slowed, leading to a market collapse. Numerous tech firms went under, and the downturn sparked a bear market that affected the tech sector and the broader stock market, lasting for about two years.

Recent Stock Market Bubbles:

US Housing Bubble (2007-2008):  

The US housing bubble is a prime example of a black swan event—an unpredictable occurrence with catastrophic results. Between 1996 and 2006, house prices in the US doubled, largely due to risky subprime mortgages granted to borrowers with poor credit. These loans were bundled into mortgage-backed securities and sold to investors. When borrowers began defaulting, it triggered a ripple effect, leading to the 2007-2008 global financial crisis.

China Stock Market Bubble (2015):  

In early 2015, China’s stock markets surged to a combined value of $9.5 trillion, driven by new retail investors, including farmers, often buying on credit. However, a slowing economy and government-imposed credit limits burst the bubble, causing a sharp market decline.

What are the causes of equity market bubbles?

The reason for a bubble burst is different every time; if you look at history, the causes are complex. However, some common factors can be like:

  • Herd Mentality: As stock prices rise, some investors rush to buy assets because of their underlying value and because they feel that prices will keep climbing. This can create a momentum effect, where the influx of buyers drives prices higher until the stock market bubble bursts.
  • Irrational Excitement: Sometimes, positive market sentiment is supported by constructive news, which results in investors making irrational decisions based on reactions rather than a vigilant assessment. This leads to the formation of stock bubbles.
  • Speculative fixation: Speculation is a crucial driver of stock market bubbles, and investors put money into assets, thinking the prices will rise indefinitely. This often results in overvaluation and, finally, a crash, as seen in the Dutch Tulip Mania and the Dotcom Bubble Bursts. 
  • Technological or Economic Shifts: A shift in new technologies or economic conditions often creates excitement and drives investment. For example, the Industrial Revolution and the rise of railroads impacted the bubbles in the 19th century, and the rise of the internet led to the Dot-com bubble in the 1990s. 
  • Easy Access to Credit: Often, cheap credit is the cause of these bubbles. A case in point was the US housing bubble of the 2000s. The availability of cheap credit allowed uninformed buyers to take on heavy debt, which raised home prices to unrealistic levels.
  • Market Psychology and FOMO: The fear of missing out (FOMO) is a human psychology that triggers many upheavals in life. This also contributed to bubbles in the past. Investors jumped on the bandwagon of others investing whenever there was a rise in asset price, finally reinforcing the bubble until it crashed. A similar case is the South Sea bubble and Wall Street in 1929.
  • Government Policies and Regulation: Sometimes, the government’s lack of regulation either contributed to or failed to prevent bubbles. For example, in early 2000, financial deregulation and loose mortgage lending standards resulted in the housing bubble that was ahead of the 2008 financial crisis.

Effects of Stock Market Bubbles

A market bubble can pose risks for both investors and businesses. We will discuss the two major effects that a stock market bubble can have on investors:

  • Loss of Wealth: When a stock market bubble bursts, a major consequence is the significant financial loss suffered by investors. This can affect everyone, from young investors who lose hope for their financial security to retirees who lose their life savings. A reliable share market advisory can play a key role in restoring investor confidence by offering expert guidance and insights that help rebuild trust in the market.
  • Loss of Wealth: When a stock market bubble bursts, a major consequence is the significant financial loss suffered by investors. This can affect everyone, from young investors who lose hope for their financial security to retirees who lose their life savings. A reliable share market advisory can play a key role in restoring investor confidence by offering expert guidance and insights that help rebuild trust in the market.
  • Erosion of Trust: Investors Although avoidable equity market bubbles are not possible, certain steps can be taken to minimize the risks. A piece of advice from the big bull of the Indian stock market will be helpful as it underlines the importance of investing in companies with strong basics, such as solid earnings and a proven track record of growth, rather than feeling disillusioned and hesitant to participate in the financial market again owing to stock market bubble bursts as it severely punctures their faith in the process. Conservative methods of stock portfolio management are a way of becoming more cautious for investors.

How can equity market bubbles be avoided?

Although avoiding equity market bubbles entirely is impossible, certain steps can be taken to minimize the risks. A piece of advice from the big bull of the Indian stock market will be helpful as it underlines the importance of investing in companies with solid basics, such as strong earnings and a proven track record of growth, rather than following fleeting market fads. Moreover, maintaining a diversified portfolio across different asset classes can help spread your risk and protect your investments from market volatility.

FAQ

  1. What is a famous stock market bubble?

    The US stock market crash of 1929 is a famous stock market bubble. Through the 1920s, a long period of prosperity took stock prices to peaks never seen before. From 1920 to 1929, stocks more than quadrupled in value. Many investors became influenced that stocks were a sure thing and borrowed heavily to invest more money in the market. But in 1929 the bubble burst, and stocks started down an even more quick precipice.

  2. What does a bubble mean in the stock market?

    A stock market bubble is an economic bubble that occurs when market participants drive stock prices above their value under some stock valuation system.

  3. How to detect stock market bubbles?

    A P/E ratio, which measures the price of a company’s shares relative to its earnings, is used to detect stock market bubbles. A high P/E ratio could mean that a company is overrated.

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I’m Archana R. Chettiar, an experienced content creator with
an affinity for writing on personal finance and other financial content. I
love to write on equity investing, retirement, managing money, and more.

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