Editing Stock market bubble

{{short description|Economic bubble in a stock market}}
{{Finance sidebar}}
A '''stock market bubble''' is a type of [[economic bubble]] taking place in [[stock market]]s 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 bias]]es 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.<ref name="Smith1988">{{Cite journal |last=Smith |first=Vernon L. |author2=Suchanek, Gerry L. |author3=Williams, Arlington W.  |year=1988 |title=Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets |journal=Econometrica |volume=56 |issue=5 |pages=1119–1151 |jstor= 1911361|doi=10.2307/1911361 |citeseerx=10.1.1.360.174 }}</ref> Other theoretical explanations of stock market bubbles have suggested that they are rational,<ref name="DeLong1990">{{Cite journal |last=De Long |first=J. Bradford |author2=Shleifer, Andrei |author3=Summers, Lawrence H. |author4= Waldmann, Robert J.  |year=1990 |title=Noise Trader Risk in Financial Markets |journal=Journal of Political Economy |volume=98 |issue=4 |pages=703–738 |url= http://www.j-bradford-delong.net/pdf_files/Noise_Traders_Main.pdf|doi=10.1086/261703 |s2cid=12112860 }}</ref> intrinsic,<ref name="Froot1991">{{Cite journal |last=Froot |first=Kenneth A. |author2=Obstfeld, Maurice  |year=1991 |title=Intrinsic Bubbles: The Case of Stock Prices |journal=American Economic Review |volume=81 |issue=5 |pages=1189–1214 |jstor= 2006913|doi= 10.3386/w3091|doi-access=free }}</ref> and contagious.<ref name="Topol1991">{{Cite journal |last=Topol |first=Richard |year=1991 |title=Bubbles and Volatility of Stock Prices: Effect of Mimetic Contagion |journal=The Economic Journal |volume=101 |issue=407 |jstor= 2233855|doi=10.2307/2233855 |pages=786–800 }}</ref>

== History ==
[[File:Emanuel de Witte - De binnenplaats van de beurs te Amsterdam.jpg|200px|right|thumb|Courtyard of the Amsterdam Stock Exchange ([[:nl:Beurs van Hendrick de Keyser|Beurs van Hendrick de Keyser]]) by [[Emanuel de Witte]], 1653.]]
Historically, early stock market bubbles and [[Stock market crash|crashes]] have their roots in [[Financial history of the Dutch Republic|financial activities of the 17th-century Dutch Republic]], the birthplace of the first formal (official) [[stock exchange]] and [[Stock market|market]] in history.<ref>[[John Brooks (writer)|Brooks, John]]: ''The Fluctuation: The Little Crash in '62'', in ''Business Adventures: Twelve Classic Tales from the World of Wall Street''. (New York: Weybright & Talley, 1968)</ref><ref>Neal, Larry (2005). "Venture Shares of the Dutch East India Company", in ''Origins of Value'', in ''The Origins of Value: The Financial Innovations that Created Modern Capital Markets'', Goetzmann & Rouwenhorst (eds.), Oxford University Press, 2005, pp. 165–175</ref><ref>[[Robert Shiller|Shiller, Robert]] (2011). ''Economics 252, Financial Markets: Lecture 4 – Portfolio Diversification and Supporting Financial Institutions (Open Yale Courses)''. [Transcript]</ref><ref>Petram, Lodewijk: ''The World's First Stock Exchange: How the Amsterdam Market for Dutch East India Company Shares Became a Modern Securities Market, 1602–1700''. Translated from the Dutch by Lynne Richards. (Columbia University Press, 2014, 304pp)</ref><ref>Macaulay, Catherine R. (2015). "Capitalism's renaissance? The potential of repositioning the financial 'meta-economy'”. (''Futures'', Volume 68, April 2015, p. 5–18)</ref> The [[Tulipmania|Dutch tulip mania]], of the 1630s, is generally considered the world's first recorded [[speculative bubble]] (or [[economic bubble]]).<ref>{{Cite web |last=Terrell |first=Ellen |title=Research Guides: Business Booms, Busts, & Bubbles: A Resource Guide on Economic Manias & Crashes: Tulip Mania |url=https://guides.loc.gov/business-booms-busts/tulip-mania |access-date=2025-01-07 |website=guides.loc.gov |language=en}}</ref>

== Examples ==
Two famous early stock market bubbles were the [[Mississippi Company|Mississippi Scheme]] in France and the [[South Sea Company|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 (author)|Charles Mackay]]'s 1841 popular account, ''"[[Extraordinary Popular Delusions and the Madness of Crowds]]".''

[[Image:Nasdaq Composite dot-com bubble.svg|thumb|right|The [[NASDAQ Composite]] index spiked in the late 90s and then fell sharply as a result of the [[dot-com bubble]].]]
[[Image:Nikkei 225(1970-).svg|thumb|right|The [[Nikkei 225]].]]
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 grid]]s. 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, [[Economy of Taiwan|Taiwanese]] stocks in 1987–89 and [[Japanese asset price bubble|Japanese stocks in the late 1980s]].

Stock market bubbles frequently produce hot markets in [[initial public offering]]s, 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.

== Whether rational or irrational ==
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 theory|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.<ref>Sergey Perminov, Trendocracy and Stock Market Manipulations (2008, {{ISBN|978-1-4357-5244-3}}).</ref>

To sort out the competing claims between behavioral finance and efficient markets theorists, observers need to find bubbles that occur when a readily available measure of fundamental value is also observable.  The bubble in closed-end country funds in the late 1980s is instructive here, as are the bubbles that occur in experimental asset markets.  According to the [[efficient-market hypothesis]], this doesn't happen, and so any data is wrong.<ref>{{cite news|title=How Did Economists Get It So Wrong?|url=https://www.nytimes.com/2009/09/06/magazine/06Economic-t.html|newspaper=The New York Times|date=2009-09-02|last1=Krugman|first1=Paul}}</ref> For closed-end country funds, observers can compare the stock prices to the net asset value per share (the net value of the fund's total holdings divided by the number of shares outstanding).  For experimental asset markets, observers can compare the stock prices to the expected returns from holding the stock (which the experimenter determines and communicates to the traders).

In both instances, closed-end country funds and experimental markets, stock prices clearly diverge from fundamental values.  Nobel laureate Dr. [[Vernon L. Smith|Vernon Smith]] has illustrated the closed-end country fund phenomenon with a chart showing prices and net asset values of the {{ill|Spain Fund|zh|伊利比亞美洲基金}} in 1989 and 1990 in his work on price bubbles.<ref>{{cite journal |title=Stock Market Bubbles in the Laboratory |date=2003 |journal= The Journal of Behavioral Finance |volume=4 |number=1 |pages= 7–20 |language=en |last1=Porter |first1= David P. |last2=Smith |first2=Vernon L.|author2-link=Vernon L. Smith|doi=10.1207/S15427579JPFM0401_03 |s2cid=8561988 }}</ref> At its peak, the Spain Fund traded near $35, nearly triple its Net Asset Value of about $12 per share.  At the same time the Spain Fund and other closed-end country funds were trading at very substantial premiums, the number of closed-end country funds available exploded thanks to many issuers creating new country funds and selling the IPOs at high premiums.

It only took a few months for the premiums in closed-end country funds to fade back to the more typical discounts at which closed-end funds trade.  Those who had bought them at premiums had run out of "greater fools".  For a while, though, the supply of "greater fools" had been outstanding.

== Positive feedback ==
A rising price on any share will attract the attention of investors. Not all of those investors are willing or interested in studying the intrinsics of the share and for such people the rising price itself is reason enough to invest. In turn, the additional investment will provide buoyancy to the price, thus completing a [[positive feedback]] loop.

Like all dynamic systems, financial markets operate in an ever-changing equilibrium, which translates into price [[Volatility (finance)|volatility]]. However, a self-adjustment ([[negative feedback]]) takes place normally: when prices rise more people are encouraged to sell, while fewer are encouraged to buy. This puts a limit on volatility. However, once positive feedback takes over, the market, like all systems with positive feedback, enters a state of increasing [[Economic equilibrium|disequilibrium]]. This can be seen in financial bubbles where asset prices rapidly spike upwards far beyond what could be considered the rational "economic value", only to fall rapidly afterwards.

==Effect of incentives==
Investment managers, such as stock [[mutual fund]] managers, are compensated and retained in part due to their performance relative to peers. Taking a conservative or contrarian position as a bubble builds results in performance unfavorable to peers.  This may cause customers to go elsewhere and can affect the investment manager's own employment or compensation. The typical short-term focus of U.S. equity markets exacerbates the risk for investment managers that do not participate during the building phase of a bubble, particularly one that builds over a longer period of time. In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the benefits outweigh the risks of not doing so.<ref>[https://www.theatlantic.com/doc/200812/blodget-wall-street Blodget-The Atlantic-Why Wall St. Always Blows It]</ref>

==See also==
* [[:fr:Histoire des bourses de valeurs|Histoire des bourses de valeurs]] (French)
* [[2008 financial crisis]]
* [[Asset allocation]] 
* [[Business cycle]]
* [[Collective behavior]]
* [[Diversification (finance)]]
* [[Dot-com bubble]]
* [[Fictitious capital]]
* [[Financial modeling]]
* [[Financial risk management]] 
* [[Irrational exuberance]]
* [[Market trend]]
* [[Risk management]] 
* [[Stock market crash]]

==References==
{{reflist}}

==External links==
* Accounts of the [[South Sea Bubble]], [[John Law (economist)|John Law]] and the [[Mississippi Company]] can be found in [[Charles Mackay (author)|Charles Mackay]]'s classic [[Extraordinary Popular Delusions and the Madness of Crowds]] (1843) – [http://www.gutenberg.org/browse/authors/m#a516 available from Project Gutenberg]. Warning: this reference has been widely criticized by historians.

{{Financial bubbles}}
[[Category:Behavioral finance]]
[[Category:Economic bubbles]]
[[Category:Market trends]]
[[Category:Stock market]]

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