Definition of Stock Market Bubble
Economists and financial professionals often talk about economic bubbles. At their most basic, any kind of economic bubble is not a positive event because all bubbles eventually burst. Fully comprehending the definition of a stock market bubble involves understanding the markets and the type of market conditions in which the bubbles occur and how they grow. In the case of stock market bubbles, they only occur in equity markets, exacerbated by a secular bull market.
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Equity Markets
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Equity markets are the buying, selling and trading of stocks over the counter (OTC) or via a stock exchange such as the New York Stock Exchange (NYSE) or the American Stock Exchange (AMEX). Broker/dealers do not buy and sell OTC securities on an exchange because the companies that issue the stocks are often too small and do not meet SEC listing requirements. OTCs are generally more volatile investments as compared to securities traded on an exchange.
Secular Bull Markets
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Secular bull markets are when the market as a whole is on an upswing because investor confidence is high, which induces investors to buy more securities. When this occurs, the demand for securities increases, while the supply stays the same. This consequently drives stock prices higher. During secular bull markets, intra-day trading may fall, but never enough to erase the gains of the overall market. Secular bull markets occur for long periods, spanning many years. Stock market bubbles occur during a time of extended growth, which is why they only happen during secular bull markets.
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Stock Market Bubble Growth
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A stock market bubble occurs when the prices of stocks increase considerably. Since stock market bubbles only occur during secular bull markets, investor confidence is already high. The increase in price caused by the growing bubble induces investors to buy even more, driving prices up even further. Eventually, the investing public and not just those in the financial services industry, catches on and begins buying stocks, which drives the stock prices up and further increases the size of the stock market bubble.
Bursting Stock Market Bubbles
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The high stock prices driven by the investor buying spree are not sustainable. Some investors know that the price of the stock is unrealistically inflated and unsustainable, so they begin selling their stock before the price falls. Then, other investors follow suit and begin selling their stocks, driving prices down. The investing public also begins selling their stock, further driving down prices. This cycle continues until the stock market bubble officially bursts.
Stock Market Bubble Bursting Effects
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Many times, a stock market crash and economic slowdown follow a bubble burst. During the growth period of a stock market bubble, stock prices falsely inflate because their perceived prices by investors are much higher than their actual worth. When the bubble begins to burst and the sell-off begins, the stock market drops significantly. A significant drop in the market causes investor sentiment to turn negative. Many of the business that grew exponentially during the stock market bubble end up going bankrupt, causing unemployment rates to increase. Because of all these factors, business and consumer spending decreases and the economy as a whole begins to slow down.
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References
- Photo Credit Stock Market Crash image by Paul Heasman from Fotolia.com
