A bubble refers to the surge in the price of an asset or commodity so that its price exceeds its intrinsic value and/or historical prices (Sorescu, et al., 2018). In the stock market, a bubble essentially refers to the Overvaluation Of Stock Prices (Sorescu, et al., 2018). A stock market bubble can be identified through metrics such as the price to earnings ratio. Specifically, if the price to earnings ratio is two-fold the normal rates a bubble may be underway. A bubble is expected to end when the bubble “bursts” which refers to the sudden and unexpected crash in prices that occurs when investors sell their stake in the stock (Virtanen, et al., 2018). The current report seeks to discuss the history and origins of stock market bubbles. Further, the report will attempt to elaborate on the underlying reasons for stock market bubbles, especially through the lens of behavioral finance. Markedly, the report focuses largely on stock market bubbles that occurred in the Bretton Woods Era spanning from 1971 to date. The next section details the history and origins of stock market bubbles and other bubbles. It is followed by a selection of five stock market bubbles in history alongside the rationale for incorporating them into the current report. The third section explores the behavioural explanations for stock market bubbles. The last section concludes the report.
The history of stock market bubbles can be traced back to the 1630s. The first stock market bubble occurred in the Dutch Republic- it is referred to as the Dutch Tulip Mania (Lodewijk, 2014). The bubble occurred when speculative activities of traders in Holland led to the surge of Tulip prices to unprecedented levels (Lodewijk, 2014). Other historical stock market bubbles include the South Sea Bubble in England and the Mississippi Scheme in France. More recent bubbles include the nifty fifty, the dot-com bubble, the Japanese asset price bubble, the US housing bubble and the Chinese Stock Market bubble. Notably, all the preceding bubbles occurred because of speculative trading by investors that led to the overpricing of the assets above their intrinsic value. The bubbles eventually crashed because of their unsustainability and disconnection from the underlying value. Markedly, the stock market bubbles are attributed to cognitive biases that cause herd behaviour and groupthink (Kapoor & Prosad, 2017). Other factors that may propagate a stock market bubble include incentives that are given to managers to drive the share price higher (Robin, et al., 2021). Another linked phenomenon is positive feedback which refers to the attraction of investors to stocks whose prices are rising without considering the intrinsic value (Demirer, et al., 2019).
An economic bubble does not occur spontaneously- instead, a series of phases comprise what is referred to as a bubble. According to Minsky(1986), a bubble has five stages. They are (1) displacement, (2) boom, (3) euphoria, (4) profit-taking, and (5) panic. During displacement, speculative investors get infatuated with a new trend or paradigm, such as an innovative technology like the internet or record-low interest rates (Minsky, 1986). The conducive conditions created by the displacement lead to a boom where prices increase gradually initially but gather impetus as more people come into the market (Minsky, 1986). During the boom phase, the asset/commodity or stock in issue receives a lot of media attention (Minsky, 1986). The latter causes FOMO in investors hence they rush to trade the asset/commodity or stock. The investors become more engaged in speculation in a bid to take advantage of a once-in-a-lifetime opportunity (Minsky, 1986). Notably, the boom is characterized by an increase in the number of traders and investors. In the euphoria phase, asset values/prices continue to surge while restraint and caution are abandoned (Minsky, 1986). The preceding is motivated by the perception that there will always be buyers despite the rising prices (Minsky, 1986). The phase is also characterized by the emergence of metrics and criteria that attempt to justify the rising prices (Minsky, 1986). During the profit-taking stage, the more cautious investors begin taking short positions to take the profit from the early purchase (Minsky, 1986). The cautious investors sense that the bubble will burst. Even so, it is difficult to predict when the bubble will burst (Minsky, 1986). A trigger incident can lead to the crushing of the bubble (Minsky, 1986). Markedly, the bubble cannot expand once it is crushed by a trigger incident (Minsky, 1986). This leads to panic as prices begin to fall at the same rate as they rose (Minsky, 1986). The panic causes investors to start selling the assets at any price they can get causing supply to exceed demand leading to crashing prices (Minsky, 1986).
During the late 1990s, the US market was bullish and lay the conditions for the dot-com bubble (DeLong & Magin, 2006). It was an impulsive surge in the prices of stock in the US technology sector (DeLong & Magin, 2006; Wheale & Amin, 2003). The surge in prices was spurred by aggressive investment in internet-based firms (DeLong & Magin, 2006). The prices rose sharply between 1995 and 2000 as was evident in the Nasdaq index which grew five times in size (DeLong & Magin, 2006). The panic phase of the dot-com bubble began in 2000 and continued crushing between 2001 and 2002 (Wheale & Amin, 2003). Markedly, the market was becoming bearish during that period.
A combination of speculative or trend-based investment, a flood of venture capital funding for startups, as well as the difficulty of tech startups to earn an adequate return fueled the Dotcom bubble (DeLong & Magin, 2006). Investors poured money into Internet firms hoping that they would someday become profitable (Wheale & Amin, 2003). Many investors and venture capitalists abandoned their measured approach because of fear of being left out over the growing use of the Internet (DeLong & Magin, 2006). Any firm with a “.com” after its name attracted venture capital firms looking for the next big thing (DeLong & Magin, 2006). Investors were too eager thus; they disregard conventional investment criteria in favour of dividends and capital gains that would not arrive for several years even if the business model truly functioned (DeLong & Magin, 2006).
The trigger event that pricked the bubble was the actions by Cisco and Dell who sold huge portions of their shares when the market peaked inspiring panic in the market. The vitality of dotcom enterprises started to deplete as investor funds dried up (Wheale & Amin, 2003). In a few months, dotcom enterprises with market caps of millions of dollars became worthless (Wheale & Amin, 2003). A large part of publicly listed dot-com enterprises had gone bankrupt, resulting in the loss of billions of dollars in investor money (Wheale & Amin, 2003). The Dot- com bubble was selected for this report because of its alignment to the stages of a bubble as discussed by (Minsky, 1986). Specifically, the Dot-com bubble was selected because it exemplifies how technology and innovation can act as a trigger for a stock bubble. People invested in any company that had a dot.com depicting herd behavior and group think as the underlying value of the stocks was ignored in favor of trend catching.
From 1986 to 1991, Japan had an economic bubble in which real estate and stock market values were dramatically inflated (Lee, 1995; Tomfort, 2017). The pricing bubble popped in 1992, leaving the economy of Japan in a state of stagnation (Tomfort, 2017). A fast rise of assets prices and exuberant economic activity, as well as an unregulated supply of money and bank lending, were all characteristics of the bubble (Tomfort, 2017). Aggressive quantitative easing policies at the time were linked to complacency and speculation in property and equity markets (Tomfort, 2017). The government in Japan began, perpetuated, and worsened the Japanese asset price bubble by enacting economic policies that promoted asset commercial viability, made credit easier to get, and promoted speculative trading (Tomfort, 2017).
The housing bubble in the U. S. was a property bubble that affected more than 50% of the states in the US (Goldstein, 2018). Markedly, the housing bubble sparked the mortgage crisis (Goldstein, 2018). The housing prices reached their highest at the start of 2006 and began falling towards the end of 2006 through to 2007 (Goldstein, 2018). The decline in prices continued to its lowest in 2012. One of the most significant crashes in prices was recorded in 2008 in the Case-Shiller (Goldstein, 2018). Strikingly, the popping of the housing bubble contributed significantly, to the Great Recession. The US Housing Bubble was selected for this report because it depicts how cognitive biases and other behavioral phenomena can impact stock markets. The economic prosperity in the US coupled by the low interest rates and favorable mortgage offers made people to engage in group think without considering the underlying value of the assets they were purchasing.
The Chinese stock market volatility started on 12th June 12, 201 with the bursting of the bubble and finished at the start of February 2016 (Jiang, et al., 2010). Within a month of the occurrence, a significant proportion of the value of A-shares on the Shanghai Stock Exchange was lost (Jiang, et al., 2010). Substantial aftershocks struck from around the 27th of July and “Black Monday” on the 24th of August. The Shanghai stock market had lost 30% in 3 weeks more than 50% of those listed firms asked for a trading stop to avoid additional losses (Jiang, et al., 2010). Despite the efforts of the Chinese government to stem the decline, the worth of stock markets continued to decline sharply (Jiang, et al., 2010). The Chinese stock market bubble was selected because it indicates how economic prosperity can act as a trigger event for investors to disregard sound investment strategies hence leading to bubbles.
Before its collapse in 1973, the Nifty Fifty stocks enthralled investors for over a decade. It resurrected a high-risk investment approach that had fallen out of favour since the 1929 crash (Penman, 2001). The Nifty Fifty bubble comprised of chose 50 equities that represented some of the fastest-growing large-cap corporations in existence in the 1960s (Penman, 2001). The Nifty Fifty bubble was characterized by a shift from an investment based on value to an investment based on blind growth (Penman, 2001). The Nifty Fifty was selected for the current report because it is a representation of the implications of investor actions based on group think and cognitive bias.
The behaviour of investors in stock market bubbles has been identified as a key driver for the phenomenon. For instance, Batmunkh, et al.(2018) argues that the surge in prices during the first three stages of a stock market bubble is a result of cognitive biases that impede critical thinking and cause investors to become part of groupthink and herd mentality. The cognitive biases that lead to the latter include overconfidence, herd behaviour, and self-attribution bias (Batmunkh, et al., 2018). The herding behaviour and groupthink lead to increased demand as more investors purchase a stake in stock that is trending (Batmunkh, et al., 2018). The latter idea is reinforced by Kapoor & Prosad(2017) who argue that financial decisions in the stock market are not rational. Instead, the decisions are a result of underaction and overreaction to new information (Kapoor & Prosad, 2017). Therefore, financial decisions are not influenced by limitations in human judgement. These limitations are referred to as cognitive biases by Batmunkh, et al.(2018) and they are largely responsible for the start, development and bursting of a stock market bubble. Essentially, information during the displacement phase of the bubble causes investors to buy more stakes in stock without considering the underlying value. The media also contributes to the stock market bubbles by providing information that encourages speculative behaviour.
Notably, the behavioural explanations to stock market bubbles contrast traditional understandings of a rational investor which assumes that investors have access to perfect information and they use the information to make correct decisions in the market (Ritter, 2003). In the real world, there is imperfect information and investors’ judgment is limited by cognitive biases and heuristics that influence decisions outcomes (Levine & Zajac, 2007). Cognitive biases have an impact on actual investors. These biases are shown in their actions, causing them to make inferior judgments. Such large-scale choices can produce market disturbances such as stock market bubbles. Such abnormalities must be avoided because they can harm individual financial health and the economic health of entire countries. Similary, Pan(2020) linked the occurrence of stock market bubbles to optimism which is a cognitive bias. The over-optimism by many investors throughout the market leads to a market sentiment that is positively associated with the occurrence and size of bubbles (Pan, 2020).
Conclusion
Stock market bubbles have been occurring since the first-ever recorded exchange in the Dutch Republic. Specifically, the Dutch Tulip Mania is the first-ever stock market bubble that was ever recorded. Since then, more economic bubbles have been recorded- for instance, the dot-com bubble, the Japanese Asset Price Bubble, the US Housing Bubble, the Chinese Stock Market Bubble and the Nifty Fifty bubble discussed herein. A stock market bubble is caused by a trigger event such as an innovation or the dissemination of information that sparks an aggressive rise in prices and not the underlying value. Eventually, the rise in prices becomes unsustainable and the bubble bursts leading to a sharp decline in the prices. The preceding report identified five stages of a stock market bubble (1) displacement, (2) boom, (3) euphoria, (4) profit-taking, and (5) panic. Notably, the occurrences leading to the stock market bubble can be explained by behavioural finance theories. There is a myriad of behavioural finance theories such as the behavioural asset pricing model-however, the current report focused on cognitive biases as reasons for the irrational behaviour of investors in stock market bubbles. Essentially, biases such as over-optimism, self-attribution, herd mentality and group think the cause is translated to trading decisions by individual investors. If the latter occurs on a larger scale, a stock bubble occurs. I learned that stock markets are influenced by both technical and behavioral factors- thus, all investment decisions should be based on the underlying value of an asset rather than group think or herd mentality.
References
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