Rises and falls are part of the stock market. We often get happy seeing the constantly rising stocks and fear the downside when the stocks lose their value rapidly for a particular period. These phases are known as stock market bubble and stock market crashes.
This article will guide you on what a bubble is, the types of bubbles, what a stock market bubble is, what causes stock market bubbles, the different stages of a stock market bubble, what happens when a bubble bursts, what a stock market crash is and what causes a stock market crash.
What Is A Bubble?
A bubble, in an economic context, refers to a situation in which market prices of various assets rise rapidly. During a financial bubble, the financial assets trade at significantly higher prices than their intrinsic value.
Types Of Bubbles
- Asset market bubble: When any asset class other than the equities, such as real estate, goes through a quick price rise, it is known as an asset market bubble. Some examples of asset market bubbles can be rapid rises in cryptocurrency values and the US housing bubble that peaked in 2006.
- Commodity bubble: When any commodity, such as gold, natural gas, etc., sees a rapid price increase, it is called a commodity bubble.
- Stock market bubble: When stocks see a rapid price increase, it is called the stock market bubble.
- Credit bubble: When there is a significant increase in retail and corporate loans or any other form of credit, it is called a credit bubble. A credit bubble has the potential to significantly hamper economic growth as defaults may increase.
Let’s look at the stock market bubble in detail.
What Is A Stock Market Bubble?
A stock market bubble is a phase in which the stock prices increase at a rapid pace, without any significant changes in the fundamental elements of the companies, such as revenue, profit, future outlook, etc.
What Causes The Stock Market Bubble?
One of the drivers of the stock market bubble is speculation. The demand for stocks starts quickly increasing when people are excited about some events and, therefore, are optimistic about the stocks.
If the stock price keeps rising, it may create a fear of missing out (FOMO). It means more investors want to buy the stocks to avoid missing the opportunity others are using. Thus, investors’ tendency to blindly copy what others are doing leads to a stock market bubble.
5 Stages Of Stock Market Bubble
Stock market bubbles usually occur in five stages.
- Displacement: The stock market bubble begins with a displacement of investors’ old beliefs/concepts or a paradigm shift. It may include a notable instance or introduction of a newer concept that increases investors’ expectations of stock performance.
- Boom: While displacement is an initial stage, the actual rapid price growth is part of the boom stage. With higher expectations, some investors start speculating about the stock and spread words about their returns and expectations with others. In this stage, the stocks gain more popularity and attract numerous investors.
- Euphoria: As the stock prices overgrow, it attracts many investors who fear missing the opportunity to gain higher returns. Many investors buy the stocks in the FOMO rather than any fundamental justification. The stock prices reach their peak during the euphoria stage.
Investors, in this phase, believe that no matter how much the stock prices increase, someone will always be ready to pay more for the stocks, and therefore, they can sell them at a higher price.
- Profit-taking: After a point, some investors see it as a red signal to hold the stocks further, and instead, they find it a good time to exit their positions to reap a profit.
- Panic: While some investors sell out their stocks in the profit-taking stage, some investors hold with the expectations of price going up. However, after a point, the stock market bubble reaches its limit and is about to burst. Investors start realising that selling stocks in the future may bring them loss, and many investors may get trapped and sell in panic.
As more investors start selling their positions, the prices start declining. At last, the stock market bubble bursts.
What Happens When A Bubble Bursts?
A stock market bubble bursts when the demand for stocks declines, and the prices fall rapidly. The stock prices may fall at a higher rate than they increased. The bursting of the stock market bubble often erodes the profit of investors. Usually, the stock market bubble is followed by a stock market crash.
What Is A Stock Market Crash?
A stock market crash refers to a situation in which most stocks and benchmark indexes suffer a drastic decline. The stock market crashes are often the result of panic selling, and panic selling in response to a market crash makes the collapse more severe.
What Causes A Stock Market Crash?
One of the reasons for the stock market crash is the bursting of the stock market bubble. Other causes of the stock market crash include natural disasters, political instability, economic crisis, higher inflation rates, etc.
The stock market bubble is an instance in which stock prices suddenly increase dramatically. The prices keep rising to a point and then fall rapidly, resulting in a stock market crash.
Many investors are skeptical about whether the Indian stock market is in a bubble currently. However, there is no full-proof assurance that the Indian stock market is in a bubble.
The traders can benefit from a stock market bubble and crash by making wise decisions. However, both situations involve a considerable amount of risk.
For long-term investors, it is advisable not to panic in such instances. It will help if you hold fundamentally sound stocks and rebalance your portfolio whenever required.
At WealthDesk, we help you make your investment journey easier by enabling you to invest in readymade WealthBaskets, which are the combinations of equities and ETFs that reflect an idea, theme, or strategy. SEBI registered professionals manage these WealthBaskets.
A primary cause of the stock market bubble burst is the shortage of money due to the credit crunch. The credit crunch can be a reason for panic selling, thereby higher supply and lower demand for stocks, resulting in declining stock prices.
Below are some signs of a bubble you can use to spot a stock market bubble.
– The stocks are traded at higher prices than their fundamental values and keep rising.
– The prices of other risky assets also keep rising.
– Credit is available at cheaper rates.
There is no fixed timeline for which the stock market crash will last. Some historical stock market crashes lasted for months, while some severe ones lasted more than five years.
A stock market crash does not necessarily mean you lose all your money. Although it is an instance where most stocks see a price fall, you may lose some of your money if you exit your positions at that time.
When the stock market crashes, keep patience and avoid the urge to sell in panic. You can rebalance your portfolio if needed. Plus, you can buy your favourite stocks at a lower price with your savings. However, it is not advisable to purchase the stocks only because they are trading at lower prices.