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Encyclopedia > Stock market bubble

A stock market bubble is a type of economic bubble taking place in stock markets when price of stocks rise and become overvalued by any measure of stock valuation. Currier & Ives print on economic bubbles, 1875. ... A stock market is a market for the trading of company stock, and derivatives of same; both of these are securities listed on a stock exchange as well as those only traded privately. ... For other uses, see Stock (disambiguation). ... It has been suggested that this article or section be merged into Fundamental analysis. ...


The definition and the existence of such bubbles has been disputed, because rising stock prices, even if dramatically or above historical level, cannot alone constitute evidence of a bubble [1]. The existence of market bubbles seems at odds with common assumptions regarding the efficiency of markets, especially financial markets, and thus is problematic for proponents of efficient market theory. Even more puzzling is the finding that bubbles occur not only in real-world markets, with their inherent uncertainty and noise, but also in highly predictable experimental markets [2]. 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 distribution probability of dividends. Although bubbles are important in their consequences, the causes of bubbles are not well understood. Theoreticians have suggested that bubbles are rational [3], intrinsic [4], and contagious [5], but there is no widely accepted theory to explain their occurrence. Efficient fuked up market theory is a field of economics which seeks to explain the workings of capital markets such as the stock market. ...

Contents

Examples

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. In August 1717 Scottish businessman John Law acquired a controlling interest in the then derelict Mississippi Company and renamed it the Compagnie d’Occident (or Compagnie du Mississippi). ... Hogarthian image of the South Sea Bubble by Edward Matthew Ward, Tate Gallery More well known than The South Sea Company is perhaps the South Sea Bubble (1711 - September 1720) which is the name given to the economic bubble that occurred through overheated speculation in the company shares during 1720. ... Motto: (French for God and my right) Anthem: God Save the King/Queen Capital London (de facto) Largest city London Official language(s) English (de facto) Unification    - by Athelstan AD 927  Area    - Total 130,395 km² (1st in UK)   50,346 sq mi  Population    - 2006 est. ... // Events January 6 - The Committee of Inquiry on the South Sea Bubble publishes its findings February 11 - Sweden and Prussia sign the (2nd Treaty of Stockholm) declaring peace. ...


The two most famous bubbles of the twentieth century, the bubble in American stocks in the 1920s 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. The dot-com bubble was a speculative bubble covering roughly 1997–2001 during which stock markets in Western nations saw their value increase rapidly from growth in the new Internet sector and related fields. ...


Other stock market bubbles of note include the Nifty Fifty stocks in the early 1970s, Taiwanese stocks in 1987 and Japanese stocks in the late 1980s. The Nifty Fifty were fifty stocks listed on the New York Stock Exchange that propelled the bull market of the early 1970s. ... Taiwan, formally including the Republic of China on Taiwan and other islands, has a dynamic capitalist economy with gradually decreasing guidance of investment and foreign trade by the government. ...


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. In financial markets, an initial public offering (IPO) is the first sale of a companys common shares to public investors. ...


A rational or irrational phenomenon?

Emotional and cognitive biases (see behavioral finance) seem to be the causes of bubbles. But, often, when the phenomenon appears, pundits try to find a rationale, so as not to be against the crowd. Thus, sometimes, people will dismiss concerns about overpriced markets by citing a new economy where the old stock valuation rules may no longer apply. This type of thinking helps to further propagate the bubble whereby everyone is investing with the intent of finding a greater fool. Still, some analysts cite the wisdom of crowds and say that price movements really do reflect rational expectations of fundamental returns. Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel winner Daniel Kahneman, was an important figure in the development of behavioral finance and economics and continues to write extensively in the field. ... The New Economy is a term that was coined in late 1990s to describe the evolution of the United States and other rich countries from an industrial/manufacturing-based economy into a high technology-based economy, arising largely from new developments in the technology sector. ... The bigger fool theory or greater fool theory (also called Survivor Investing. ...


To sort out the competing claims between behavioral finance and efficient markets theorists, observers need to find bubbles that occur when a readily-available measure of fundamental value is also observable. The bubble in closed-end country funds in the late 1980s is instructive here, as are the bubbles that occur in experimental asset markets. For closed-end country funds, observers can compare the stock prices to the net asset value per share (the net value of the fund's total holdings divided by the number of shares outstanding). For experimental asset markets, observers can compare the stock prices to the expected returns from holding the stock (which the experimenter determines and communicates to the traders).


In both instances, closed-end country funds and experimental markets, stock prices clearly diverge from fundamental values. Nobel laureate Dr. Vernon Smith has illustrated the closed-end country fund phenomenon with a chart showing prices and net asset values of the Spain Fund in 1989 and 1990 in his work on price bubbles. At its peak, the Spain Fund traded near $35, nearly triple its Net Asset Value of about $12 per share. At the same time the Spain Fund and other closed-end country funds were trading at very substantial premiums, the number of closed-end country funds available exploded thanks to many issuers creating new country funds and selling the IPOs at high premiums.


It only took a few months for the premiums in closed-end country funds to fade back to the more typical discounts at which closed-end funds trade. Those who had bought them at premiums had run out of "greater fools". For a while, though, the supply of "greater fools" had been outstanding.


Stock market bubble as an example of positive feedback

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. Imbibers of alcoholic drinks the unknown strange organisms were called yeast and they were the starting point of the image. ...


In turn, the additional investment will provide buoyancy to the price, thus completing the loop.


Like all dynamical systems, financial markets operate in an ever changing equilibrium, which translates into price volatility. However instable is this balance, 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 a positive feedback takes over, the market, like all systems with positive feedback, enter 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. Volatility most frequently refers to the standard deviation of the change in value of a financial instrument with a specific time horizon. ... Negative feedback (shortened to NFB) is a type of feedback in which the system responds in an opposite direction to the perturbation. ... Price of market balance In economics, economic equilibrium or market equilibrium refers to a condition where the market clears: which is when the market for a product has attained the price where the amount supplied of a certain product equals the quantity demanded. ...


References

  1. ^ Garber, Peter (2000), Famous First Bubbles: The Fundamentals of Early Manias, MIT Press.
  2. ^ Smith, Vernon L.; Suchanek, Gerry L. and Williams, Arlington W. "Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets." Econometrica, 1988, 56(5), pp. 1119-51.
  3. ^ De Long, J. Bradford; Shleifer, Andrei; Summers, Lawrence H. and Waldmann, Robert J. "Noise Trader Risk in Financial Markets." Journal of Political Economy, 1990, 98(4), pp. 703-38.
  4. ^ Froot, Kenneth A. and Obstfeld, Maurice. "Intrinsic Bubbles: The Case of Stock Prices." American Economic Review, 1991, 81(5), pp. 1189-214.
  5. ^ Topol, Richard. "Bubbles and Volatility of Stock Prices: Effect of Mimetic Contagion." The Economic Journal, 1991, 101(407), pp. 786-800

See also

// [edit] Introduction [edit] Definition If we were to take snapshots of an economy at different points in time, no two photos would look alike. ... Collective behavior is a specialized term in sociology. ... Fictitious capital is a concept used by Karl Marx in his critique of political economy. ... Bull and bear statues in front of the Frankfurt Stock Exchange In investing, financial markets are commonly believed to have market trends that can be classified as primary trends, secondary trends (short-term), and secular trends (long-term). ... In August 1717 Scottish businessman John Law acquired a controlling interest in the then derelict Mississippi Company and renamed it the Compagnie d’Occident (or Compagnie du Mississippi). ... The Poseidon bubble was a stock market bubble in which the price of Australian mining shares soared in late 1969, then crashed in early 1970. ... The unsustainable geometric progression of a classic pyramid scheme A pyramid scheme (also known as Pyramid Scam [1]) is a non-sustainable business model that involves the exchange of money primarily for enrolling other people into the scheme, usually without any product or service being delivered. ... Railway mania was the term given to the speculative frenzy in Britain in the 1840s. ... Hogarthian image of the South Sea Bubble by Edward Matthew Ward, Tate Gallery More well known than The South Sea Company is perhaps the South Sea Bubble (1711 - September 1720) which is the name given to the economic bubble that occurred through overheated speculation in the company shares during 1720. ... // Pamphlet from the Dutch tulipomania, printed in 1637 The term tulip mania (alternatively tulipomania) is used metaphorically to refer to any large economic bubble. ... Diversification in finance involves spreading investments around into many types of investments, including stocks, mutual funds, bonds, and cash. ...

External links


  Results from FactBites:
 
The Costs of the Stock Market Bubble, by Dean Baker, CEPR, Nov. 2000 (10580 words)
It is also likely that a stock market correction will lead to a sea of litigation as investors try to recover some of their losses from corporations that provided misleading information or brokers who gave bad advice.
It is possible that in aggregate, stock market induced consumption may have a significant negative impact on the purchasing power of the rest of the population in the areas outside of housing, but it would be difficult to try to measure this effect.
In each case, it is assumed that the stock market in subsequent years rises at the same rate as corporate profits, which is assumed to be equal to the growth of the economy.
Stock market bubble: Definition and Links by Encyclopedian.com (379 words)
A Stock market bubble is a type of economic bubble in which an exaggerated bull market where the value of stocks listed on a stock exchange rise dramatically upon a wave of public enthusiasm.
Still other examples of stock market bubbles include Japanese stocks in the late-1980s, Nifty 50 stocks in the early 1970s, and Taiwanese stocks in 1987.
A stock market bubble may set the stage for a later stock market crash, continuing our example, the Stock Market Crash of 2002.
  More results at FactBites »

 
 

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