The Equity Market Bubble: A Comprehensive Guide

Equity market bubbles are a real phenomenon, and they've happened many times before. In fact, the US stock market experienced a significant bubble in the late 1990s.

Investors who got in on the ground floor of the internet boom saw their portfolios skyrocket, but many of them also lost big when the bubble burst in 2000. The S&P 500 index fell by over 30% in a single year.

The warning signs of a bubble can be subtle, but they're often there. For example, in the years leading up to the 2008 financial crisis, housing prices rose at an unsustainable rate.

An equity market bubble is a complex phenomenon characterized by an unsustainable desire to satisfy a legitimate market in high demand.

Easy liquidity plays a significant role in equity market bubbles, allowing investors to quickly buy and sell assets.

The Tulip Mania, a classic example of an equity bubble, saw people investing in tulip bulbs, which led to a surge in prices and eventually a crash.

Tangible and real assets are often involved in equity market bubbles, making them seem more secure than they actually are.

Bitcoin is another instance of an equity bubble, with its value skyrocketing due to an actual innovation that boosted confidence.

The dot-com bubble also exhibited these characteristics, with investors pouring money into internet-based companies, only to see their values plummet.

An actual innovation is often the driving force behind equity market bubbles, as it boosts confidence and attracts more investors.

Equity market bubbles can arise from a combination of factors, including low interest rates, foreign investment, and new products or technologies. These factors can create an environment where prices rise due to demand-pull inflation.

Bubbles can occur even in highly predictable experimental markets, where uncertainty is eliminated and market participants should be able to calculate the intrinsic value of the assets. This suggests that bubbles are not solely caused by bounded rationality or assumptions about the irrationality of others.

Recent theories suggest that asset bubbles are likely sociologically-driven events, influenced by culturally-situated narratives and the prevailing institutions of the time. For instance, bubbles often form during periods of innovation, easy credit, and loose regulations.

Some common characteristics of equity market bubbles include:

These behaviors can lead to bubbles feeding on themselves and growing out of proportion to the fundamentals of the assets involved.

There are two major types of bubbles that economists primarily focus on: equity bubbles and debt bubbles. These bubbles have distinct characteristics that set them apart from other types of bubbles.

An equity bubble occurs when the price of stocks or equities rises rapidly, often out of proportion to their companies' fundamental value. This can happen in the overall stock market or in specific sectors, like the dot-com bubble of the late 1990s.

A debt bubble, on the other hand, involves a sudden surge in consumer or business loans, debt instruments, and other forms of credit. This can lead to a rapid increase in the prices of assets like corporate bonds or government bonds.

Here are the four basic categories of asset bubbles:

Causes of asset bubbles are complex and multifaceted. Excessive leverage is a key factor that can cause financial bubbles, according to recent computer-generated agency models.

Bubbles can occur even in highly predictable experimental markets, where uncertainty is eliminated and market participants should be able to calculate the intrinsic value of the assets simply by examining the expected stream of dividends. This has been observed repeatedly in experimental markets, even with participants such as business students, managers, and professional traders.

Low interest rates can encourage borrowing for spending, expansion, and investment, which can lead to asset bubbles. This can be further fueled by an influx of foreign investment and purchases, as well as new products or technologies that spur demand and drive up prices.

New products or technologies can create a high demand for a particular asset, causing its price to rise. This is an example of demand-pull inflation. However, when an asset bubble begins to form, it can start to feed on itself and grow out of proportion to the fundamentals of the asset.

Some common factors that contribute to the formation of asset bubbles include low interest rates, easy credit, loose regulations, and internationalized investment. These factors can create a perfect storm that leads to a bubble.

Here are some key factors that can contribute to the formation of asset bubbles:

It's worth noting that bubbles can occur even when market participants are well capable of pricing assets correctly, and when speculation is not possible or when over-confidence is absent.

Liquidity is a key concept in finance, and it refers to the ability of an asset to be easily converted into cash without significantly affecting its price.

High liquidity is often associated with assets that are widely traded, such as stocks and bonds.

The liquidity of an asset can be measured by its market depth, which is the amount of buying and selling interest at a given price level.

A highly liquid asset can be quickly and easily sold for cash, whereas a less liquid asset may take longer to sell and may result in a lower price.

In the context of stocks, liquidity can be affected by factors such as the size of the company, the number of shares outstanding, and the trading volume.

The impact of an equity market bubble can be devastating. It's not just about the money lost, but also the economic malaise that can follow.

A protracted period of low risk premiums can prolong the downturn in asset price deflation, as seen during the Great Depression in the 1930s and Japan's economic downturn in the 1990s. This can have far-reaching effects on a nation's economy and even reverberate beyond its borders.

Market participants with overvalued assets tend to spend more, feeling richer due to the wealth effect. This was evident in the housing market in the UK, Australia, New Zealand, Spain, and parts of the US in recent times.

The crash that usually follows an economic bubble can destroy a large amount of wealth, causing economic growth to slow down or even exacerbate the economic slowdown.

Economic bubbles can have a significant impact on the economy, and it's not all bad news, but mostly bad. Many mainstream economists believe that bubbles can't be identified in advance and can't be prevented from forming.

The aftermath of a bubble burst can be devastating, destroying a large amount of wealth and causing continuing economic malaise. This view is particularly associated with the debt-deflation theory of Irving Fisher and elaborated within Post-Keynesian economics.

A protracted period of low risk premiums can simply prolong the downturn in asset price deflation, as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan. This can have far-reaching effects, not just within a nation's economy but also beyond its borders.

The crash that usually follows an economic bubble can be particularly damaging if it's fueled by debt. Research has shown that the more credit involved, the more damaging the bubble's pop, with debt-fueled equity bubbles leading to longer-lived recessions.

Market participants with overvalued assets tend to spend more because they "feel" richer, but this can be a double-edged sword. When the bubble inevitably bursts, those who hold on to these overvalued assets usually experience a feeling of reduced wealth and tend to cut discretionary spending, hindering economic growth.

Incentives play a significant role in shaping the behavior of investment managers, particularly during the formation of a financial bubble.

Investment managers are often compensated and retained based on their performance relative to their peers. This can lead to a short-term focus, as they try to maximize returns for clients and maintain their employment.

The typical short-term focus of U.S. equity markets exacerbates the risk for investment managers who don't participate during the building phase of a bubble, especially one that builds over a longer period of time.

Investment managers may rationally participate in a bubble they believe to be forming, as the benefits outweigh the risks of not doing so. This is evident in the commercial revolution (1000–1760), where investment managers likely participated in the growing economy.

Here are some key periods where incentives may have influenced investment manager behavior:

The information age (2007–present) has seen the rise of new investment opportunities and technologies, which may have influenced investment manager behavior. However, the exact impact of incentives during this period is not specified in the article section facts.

Some bubbles burst others buzz, and it's fascinating to see the difference in their behavior.

Bursting bubbles, like utilities in 1929 and software in 1999, end with a negative return of about 30% in the two years following.

These bubbles start to lose steam around month nine, marking a turning point in their trajectory.

Buzzing bubbles, on the other hand, experience a similar two-year run-up in prices but see no subsequent price drawdown.

In fact, returns of buzzing bubbles continue upwards, gaining an additional 50% positive return.

Examples of buzzing bubbles include gold in 1980 and steel in 2007.

A speculative bubble in the equity market can be a complex and unpredictable phenomenon. According to economist Charles P. Kindleberger, a bubble typically goes through five phases: Displacement, Boom, Euphoria, Financial distress, and Revulsion.

These phases are characterized by unusual changes in asset prices and relationships among measures, such as the price-to-earnings ratio. For example, in the housing bubble of the 2000s, housing prices were unusually high relative to income.

During the Boom phase, asset prices rise rapidly, and investors become increasingly optimistic about future returns. This optimism can lead to a detachment from real rational valuable objects, as investors focus on short-term gains rather than long-term stability.

The Euphoria phase is marked by a democratization of speculative investments, with more and more people participating in the market. However, this can also lead to a situation where prices begin to plateau, and investors start considering selling to cover their liabilities.

A bubble can be identified by several key characteristics, including elevated usage of debt to purchase assets, higher risk lending and borrowing behavior, and rationalizing borrowing and purchase decisions based on expected future price increases. These characteristics can be seen in the following list:

These characteristics can be a warning sign that a bubble is forming, and investors should be cautious of such situations. By understanding the stages and identification of a speculative bubble, investors can make more informed decisions and avoid getting caught up in the hype.

The stock market is just one of the many asset classes that can experience a bubble. In fact, any asset can be affected, including cryptocurrencies like Bitcoin and Dogecoin, which rose to unsustainable prices in 2016-2017 and again in 2021-present.

Real estate is another classic example of an asset market bubble, where run-ups in housing prices can be unsustainable. This was the case in the late 1880s and early 1890s in Brazil, known as the Encilhamento.

Stock market bubbles can also lead to a more general economic bubble, where a regional or national economy overall inflates at a dangerously fast clip. This was the case in the 1920s in the United States, leading to the meltdown of the Crash of 1929 and the subsequent Great Depression.

Here are some notable examples of asset bubbles by class:

The Japanese asset price bubble of the late 1980s is a notable example of a multi-asset bubble. It's a fascinating case study of how a combination of factors can lead to a broader economic bubble.

The Japanese asset price bubble occurred from 1986 to 1991, and it involved a surge in prices across various asset classes, including real estate, stocks, and bonds. This bubble was fueled by a combination of low interest rates, excessive borrowing, and speculation.

One of the most striking aspects of the Japanese asset price bubble was its impact on the country's economy. The bubble led to a sharp increase in asset prices, which in turn fueled consumption and investment. However, when the bubble burst, the economy was left with a massive debt burden and a significant decline in asset values.

The 1997 Asian financial crisis is another example of a multi-asset bubble. It was a regional economic crisis that began in Thailand and spread to other countries in the region, including Indonesia, Malaysia, and South Korea. The crisis was triggered by a combination of factors, including a decline in exports, a sharp increase in interest rates, and a loss of investor confidence.

Here are some notable examples of multi-asset bubbles:

The extent of exceptional forward purchases is a key indicator of whether expectations have become overly optimistic. This gauge is particularly helpful in commodity and real estate markets, where forward purchases are most clear.

In the equity markets, we look at indicators like capital expenditures. For listed US companies, these are still at relatively low levels.

Pending M&A deals are another area where we can assess if buyers are making forward purchases of stock for cash. As of now, pending cash M&A deals are not particularly elevated.

Forward purchases look frothy for the Mag-7 companies. They're investing significantly, with capex at all-time highs, both versus their own sales and as a share of the economy.