What Is a Bubble in Relation to the Stock Market?
A bubble is an overvaluation of the stock market as a whole or in a particular stock group caused by excessive public enthusiasm or "madness of crowds." Stocks in a bubble trade above any reasonable measure of valuation. A bubble has several distinct signs.
Other People Are Reading
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It's Not a Bubble
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The majority believe there is no bubble. They usually have a "reasonable" explanation as to why. Internet stocks were not in a bubble because they represented the "new economy", in which standard valuation methods of valuation did not apply, so the Internet stocks were "reasonably" priced.
This Time It's Different
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This may the most dangerous statement in stock investing, which has cost countless investors billions of dollars. Investors accept that something is not as it should be but have an explanation as to why it's OK "this time." The Japanese stock market was grossly overvalued in the '80s but the longer it stayed overvalued, the more "learned" explanations were advanced as to why the Japanese market was different and traditional methods valuation did not apply. During the Internet bubble, analysts valued stocks based on clicks or eyeballs.
Bubbles never occur twice in the same place, reinforcing the belief that "this time it's different."
Why Bubbles Occur
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The collective memory of stock market participants is shorter than major stock market cycles and trends. When not enough people are left to remember the previous bubble, the conditions are ripe for another to emerge.
Buying can feed on itself. The more prices rise, the more buyers are drawn in and the more ridiculous the explanations to justify current valuations.
How Bubbles Burst
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Stock trading, especially in a bubble, is based on a greater fool theory--the ability to resell to someone else at a higher price. But if there are no more buyers left, to whom are investors going to sell? That's how market tops are formed: After the largest number of buyers buys there are no more buyers left and stock prices begin to sag. That's also why the majority inevitably buy at the top.
Market Losses
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Bubbles deflate much faster than they form, as the recently enthusiastic buyers sell in a panic. Losses of 50 percent to 90 percent are not uncommon.
Denial and Manipulation
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Many latecomers refuse to believe that the party is over and attempt to prop up their holdings by posting cheerleading messages on stock message boards and telling everyone who will listen why it is just a temporary pullback and a buying opportunity. Institutions that have accumulated large positions in bubble stocks need a market to sell into so they keep circulating rosy reports to keep the general public buying.
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