What Is a Stock Market Bubble?

A stock market bubble is when share prices climb too far beyond fundamental values. The steep ascent is almost always followed by a sudden plunge. 

Stock market bubbles typically occur when investors overvalue equities, either because they’ve engaged in excessive speculation, relied on bad information, or misjudged valuations. Growth expectations become exaggerated as irrational exuberance takes over. When the bubble pops, massive sell-offs cause prices to fall quickly below the security’s starting value. This can happen with the entire stock market, but it can also occur with an individual stock, a sector of the market, or an asset class. 

Of course, not every surge in stock prices is a sign of a bubble. For instance, a company’s strong performance and competitive advantage can justify significant stock gains. 

Bubbles probably have been around for as long as humans have traded goods and services. Although bubbles are difficult to identify while they are occurring and only become obvious in retrospect, they can have profound effects on the economy. 

In late 1636, for example, the price of tulips in Holland spiked far beyond their worth as speculators bought them to flip later at a profit. Prices crashed only a few months later, and the flowers eventually sold for a fraction of their peak prices. 

More recently, many internet startups became overvalued during the 1990s as speculation and fervor drove prices to extremes. The broader S&P 500 more than doubled in value in a matter of years, while the technology-dominated Nasdaq Composite index surged by 582% between January 1995 and March 2000. The dot-com bubble burst later that year, triggering a bear market and ultimately a recession. By 2002, the Nasdaq had lost 75% of its value. 

After the dot-com bust, the US housing market went through its own bubble, starting in the early 2000s. Amid loosening credit standards and interest rates at historic lows, demand for houses climbed. Investors bought mortgage-backed securities, speculators began to flip homes in hopes of turning a profit, and home prices rose by almost 80% between 2000 and 2006. The bubble eventually burst, touching off a full-blown global financial crisis. It took about 10 years for housing prices to recover fully.

Positive feedback, also known as a positive bubble loop, is a pattern of investment behavior that propels market growth. For instance, prices might start climbing when investors buy securities and then sell for higher returns. Other investors buy that security in the hopes they can profit from a continued rise in price. Whatever starts the loop becomes self-sustaining, so the cycle feeds on itself.

When this happens because of an underlying reality in the market—for instance, a company or industry is getting stronger—the positive feedback loop can be a good thing. However, prolonged positive feedback can lead to irrational expectations, which may give rise to an asset bubble. 

In a negative feedback loop, poor economic conditions build on each other and create a pattern of contraction. This typically happens when a bubble bursts. Investors start selling their positions to reduce their losses, which pushes down prices and prompts other investors to do the same.

Stock market bubbles follow the same basic pattern that was first identified by American economist Hyman Minsky. 

1. Displacement. In the first stage of a bubble, a change or an innovation that promises radical transformation prompts investors to think differently about the market and their expectations for a certain asset. The price of that asset slowly starts rising. 
2. Boom. As word spreads about the asset’s gains, momentum pushes prices higher. Media coverage focuses on the asset, and fear of missing out on a “once in a lifetime opportunity” drives more investors into the market. This spurs more speculation and price increases.
3. Euphoria. During this stage, people are driven more by excitement than a rational justification for what’s going on in the market. Prices skyrocket, bearing little resemblance to the assets they represent. A common rationalization offered to justify prices is that “this time is different.”
4. Profit taking. Reading the signs of a market bubble forming, investors may prepare for its collapse by selling to protect their profits.‍
5. Panic. Once the bubble is pricked, it can’t inflate again—and asset prices plunge as investors sell, quickly wiping out past gains. A market downturn may follow.