What Is a Speculative Bubble?
A speculative bubble is a spike in asset values within a particular industry, commodity, or asset class to unsubstantiated levels, fueled by irrational speculative activity that is not supported by the fundamentals.
- A speculative bubble is a sharp, steep rise in prices that is fueled by market sentiment and momentum, more than underlying fundamentals.
- The speculation is driven initially by fundamentals—such as strong profit growth or expectations of future competitive dominance—but is soon taken over by factors that don't speak to the stock or sector's intrinsic value.
- Prices spike as investors jump in to avoid missing the boat, believing that prices will continue to rise and that an opportunity will be lost if they don't invest.
- Eventually, fundamentals catch up with the momentum, the bubble pops, the stock sinks, and prices drop back to pre-bubble levels.
Understanding a Speculative Bubble
A speculative bubble is usually caused by exaggerated expectations of future growth, price appreciation, or other events that could cause an increase in asset values. This speculation and resulting activity drive trading volumes higher, and as more investors rally around the heightened expectation, demand outstrips supply, pushing prices beyond what an objective analysis of intrinsic value would suggest.
The bubble is not completed until prices fall back down to normalized levels. This process is described as a pop, which is a reference to a period of steep decline in prices, during which most investors panic and sell out of their investments. Bubbles can exist in economies, stock and bond markets, and individual sectors of the economy.
Speculative bubbles have a long history in world markets. The progression of time along with economic and technological advances has not slowed their formation. In fact, the 2001 tech bubble was spurred on by technological advances and the advent of the internet.
In 2008, the popping of the real estate bubble, along with the collapse of other real estate related asset-backed securities (ABS), helped usher in the global financial crisis. In our modern financial markets, speculators can often make profitable bets when speculative bubbles burst by purchasing derivatives or shorting securities directly.
Five Stages of a Bubble
There are five stages of a bubble, as first outlined by economist Hyman P. Minsky in his book on financial instability. Minsky was talking more specifically about the stages of a typical credit cycle, but the description also applied to bubbles.
- The first stage is displacement, meaning investors become enamored by a new innovation or development in fiscal policy, such as an extended period of low interest rates.
- The second stage is a boom, as prices tiptoe higher at first but then pick up speed as more investors jump in out of fear of missing out.
- Stage three is euphoria, in which cooler heads don't prevail and market momentum is driving the way.
- Stage four brings profit-taking, during which investors who believe the bubble will soon pop start cashing out.
- The last stage is panic, as an event or series of events causes the bubble to burst and stocks to tumble fast.
A speculative bubble may also be referred to as a "price bubble" or "market bubble."
While each speculative bubble has its own driving factors and variables, most involve a combination of fundamental and psychological forces.
In the beginning, attractive fundamentals may drive prices higher, but over time behavioral finance theories suggest that people invest so as to not "miss the boat", or the "fear of missing out (FOMO)", on high returns gained by others. When the artificially high prices inevitably fall, most short-term investors are shaken out of the market after which the market can return to being driven by fundamental metrics.