When the price of stocks surge and demand reaches a fever pitch, investors may wonder: Are we in a stock market bubble? “Stock market bubble” is a term that’s used when the market appears exceptionally overvalued, driven by a combination of heightened enthusiasm, unrealistic expectations, and reckless speculation. 

The dot-com bubble and housing market bubble are two notable examples of this phenomenon. Understanding what market bubbles are and why they happen can help investors manage their portfolios during these times.

Historical examples of stock market bubble

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 and negative bubble loops

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.

The 5 phases of a stock market bubble

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.

Types of asset bubbles

Bubbles are generally driven by speculation, so they can theoretically form in just about any asset, industry, or sector of the market. But in general, asset bubbles can be broken down into four basic categories:

• Stock market bubbles.

  Theseinvolve shares of publicly traded companies. Prices increase out of proportion to fundamental values, either in the overall market or in one particular field, like technology.

• Asset market bubbles.

  Also known as financial bubbles, asset market bubbles involve industries outside of the equities market, such as real estate or currencies.

• Credit bubbles.

  These can occur when consumers and businesses suddenly have more access to loans, such as student loans, mortgages, and other forms of debt instruments.

• Commodity bubbles.

  When the demand for a commodity, such as gold or oil, far exceeds the supply, these can happen. This superficially inflates the price of the product.

Protecting your portfolio during a stock market bubble

While it’s difficult to recognize an economic bubble when it’s forming, identifying the signs can help guide decisions. Diversification can also help. When an investor spreads risk across different types of investments, it can reduce the potential loss to their overall portfolio. But keep in mind, it’s impossible to know if and when prices on a given asset will fall.

FAQs about stock market bubbles

What causes an asset bubble?

Asset bubbles may form for any reason. For instance, a rumor, news report, or an analyst’s insight may spark short-term enthusiasm or the beginnings of an asset bubble. Then, during an asset bubble, an investor is willing to pay a price that exceeds the asset’s fundamental value. Another investor is willing to buy for an even higher price, which perpetuates a cycle of speculative fervor. Believing someone else will always be willing to invest at a higher price is known as the greater fool theory.

What happens when an asset bubble bursts?

An asset bubble starts to deflate when the positive feedback loop stalls. During the housing market bubble, for instance, many people who couldn’t afford homes stopped paying their mortgage loans and defaulted. The asset bubble bursts when people stop buying, money drains from that sector, and investors start selling to protect their profits. The price of the asset plummets, and many investors lose money in the process. This may be followed by a bear market or even a recession.

The bottom line

Stock market bubbles, and bubbles more generally, are an enduring feature of financial markets. There are well-known, often specific, reasons they occur: A new product might have real value, but enthusiasm tips into irrationality, followed by reckless speculation and an upward price spiral. The bubble inevitably pops when investors can’t find other people to buy their overpriced assets. Fervor turns into panic as investors rush to sell and as a bust follows. Bubbles may not always be obvious when they’re happening, but they become clear in hindsight.