What is Bubble Theory?

Bubble theory is an informal financial hypothesis that presumes the possibility of rapidly rising prices as investors begin buying beyond what may seem like rational prices. The hypothesis include the idea that the rapid rise in market prices will be followed by a sudden crash as investors move out of overvalued assets with little or no clear indicators for the timing of the event.

Key Takeaways

  • Bubble theory is less of an actual theory than a point of view about exuberant market behavior.
  • Prices of any asset can get much higher than apparent values warrant.
  • Investor expectations and perceptions can drive prices higher than anticipated.
  • An untimely correction of the prices can be rapid and dangerous as investors lose faith.

Understanding Bubble Theory

Bubble theory applies to any asset class that rises well above its fundamental value, including securities, commodities, stock markets, housing markets, and industrial and economic sectors. Bubbles are hard to distinguish in real time because investors can't easily judge if the market's pricing reflects the prediction of future values or merely collective enthusiasm.

For example, in the first few years after the company's IPO, shares of Amazon's stock (AMZN) traded well above 100 times its price-earnings ratio, predicting the possibility that the company's earnings (and the subsequent rally in prices) could rise by 500 percent or more. Many investors thought this was a bubble that would surely burst, but history hasn't borne out that outcome.

Bubbles that do crash create danger for investors because they remain overvalued for an indeterminate amount of time before crashing. When bubbles burst, prices decline and stabilize at more reasonable valuations, triggering substantial losses for large numbers of investors. The most recent example of bubble behavior can be observed in the price of Bitcoin from 2016 to 2019.

Excess demand causes a bubble as motivated buyers generate a quick rise in prices. The rising prices gain attention and generate more demand until enough investors realize the situation has become unsustainable and begin to sell. Once a critical mass of sellers emerges, the process reverses. As one would expect, those who buy at the highest prices typically sustain the worst losses when a bubble bursts.

Investors may find bubbles difficult to identify as they form and grow. The effort pays off if an investor recognizes the bubble before it bursts and gets out before the losses begin to mount, so many investors spend significant time and energy attempting to detect bubbles.

The Dotcom Bubble

In the late 1990s and early 2000s, investors threw money almost indiscriminately at any company involved with internet technology. As some technology companies flourished and money flowed into startups, many investors failed to perform due diligence on new firms, some of which never turned a profit or even produced a viable product. When investors eventually lost confidence in tech stocks, the dotcom bubble burst and the money flowed elsewhere, wiping out trillions of dollars of investment capital. Strangely this bubble occurred even in the midst of a world-changing technology, the spread of the internet.

Bubbles and Efficient Markets

In theory, an efficient market where asset prices reflect their true economic value would not produce a bubble. Some economic theorists believe bubbles only become visible in hindsight, while others believe investors can predict them to some degree. Since bubbles depend upon a rise in prices that outstrips the value of an asset class, it stands to reason that investors interested in identifying them should look to charts for radical price changes that occur over short periods of time. The more volatile an asset class's prices, the more difficult an investor will find it to identify a bubble’s formation, however.

The allure of a bubble lies in the massive amount of money that goes into its growth. Even an investor who recognizes the possible or probable formation of a bubble may be tempted to buy into the rise, hoping to capture profit before the eventual sell-off. The significant downside that accompanies a bursting bubble should temper such attempts for prudent investors.