Stock Market Bubbles: When Does Intervention Work? Federal Deposit Insurance Corporation (1987)




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Published on Aug 22, 2014

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. In the laboratory, uncertainty is eliminated and calculating the expected returns should be a simple mathematical exercise, because participants are endowed with assets that are defined to have a finite lifespan and a known probability distribution of dividends. Other theoretical explanations of stock market bubbles have suggested that they are rational, intrinsic, and contagious.

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 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 an amazing 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.

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

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. 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 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.

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 risks of not doing so outweigh the benefits.



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