Stock market bubble

A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation.

Behavioral finance theory attributes stock market bubbles to cognitive biases that lead to groupthink and herd behavior. Bubbles occur not only in real-world markets, with their inherent uncertainty and noise, but also in highly predictable experimental markets. Other theoretical explanations of stock market bubbles have suggested that they are rational, intrinsic, and contagious.

Historically, early stock market bubbles and crashes have their roots in financial activities of the 17th-century Dutch Republic, the birthplace of the first formal (official) stock exchange and market in history. The Dutch tulip mania, of the 1630s, is generally considered the world's first recorded speculative bubble (or economic bubble).

Two famous early stock market bubbles were the Mississippi Scheme in France and the South Sea bubble in England. Both bubbles came to an abrupt end in 1720, bankrupting thousands of unfortunate investors. Those stories, and many others, are recounted in Charles Mackay's 1841 popular account, "Extraordinary Popular Delusions and the Madness of Crowds".

The two most famous bubbles of the twentieth century, the bubble in American stocks in the 1920s just before the Wall Street crash of 1929 and the following Great Depression, and the Dot-com bubble of the late 1990s, were based on speculative activity surrounding the development of new technologies. The 1920s saw the widespread introduction of a range of technological innovations including radio, automobiles, aviation and the deployment of electrical power grids. The 1990s was the decade when Internet and e-commerce technologies emerged—many of which had minimal sales and earnings profiles.

Other stock market bubbles of note include the Encilhamento occurred in Brazil during the late 1880s and early 1890s, the Nifty Fifty stocks in the early 1970s, Taiwanese stocks in 1987–89 and Japanese stocks in the late 1980s.

Stock market bubbles frequently produce hot markets in initial public offerings, since investment bankers and their clients see opportunities to float new stock issues at inflated prices. These hot IPO markets misallocate investment funds to areas dictated by speculative trends, rather than to enterprises generating longstanding economic value. Typically when there is an over abundance of IPOs in a bubble market, a large portion of the IPO companies fail completely, never achieve what is promised to the investors, or can even be vehicles for fraud.

Emotional and cognitive biases (see behavioral finance) seem to be the causes of bubbles, but often, when the phenomenon appears, pundits try to find a rationale, so as not to be against the crowd. Thus, sometimes, people will dismiss concerns about overpriced markets by citing a new economy where the old stock valuation rules may no longer apply. This type of thinking helps to further propagate the bubble whereby everyone is investing with the intent of finding a greater fool. Still, some analysts cite the wisdom of crowds and say that price movements really do reflect rational expectations of fundamental returns. Large traders become powerful enough to rock the boat, generating stock market bubbles.