The psychology of a stock market bubble
I don’t know if the stock market is forming a bubble that’s about to burst.
But I know a lot of bulls get it wrong when they think a bubble can’t happen when a lot of us are worried about a bubble. In fact, one of the distinguishing features of a bubble is that this concern is widespread.
It seems counterintuitive. You would think that a bubble is more vulnerable to forming and then bursting when investors are oblivious to the possibility. But you would be wrong.
It is important for all of us to be aware of this bubble psychology, but especially if you are a retiree or near-retiree. Indeed, in this case, your investment horizon will be shorter than for the younger ones, and you will therefore be less able to recover from the deflation of a market bubble.
To appreciate how widespread the current concern about a bubble is, consider the attached graph of data from Google Trends. It plots the relative frequency of Google searches based on the term “stock market bubble”. Note that this frequency has recently jumped to a much higher level than at any time in the past five years.
This generalized concern is entirely consistent with the formation of a bubble, according to a definition proposed decades ago by Robert Shiller, professor of finance at Yale and winner of the Nobel Prize. According to him, a bubble is “a market situation in which news of rising prices stimulates investor enthusiasm which spreads by psychological contagion from person to person, attracting a growing class of investors, who, despite the doubts about the fundamental value, are attracted to the investment partly by the envy of the success of others and partly by the excitement of the player. (I italicized the sentence above, not Shiller.)
Note that the recognition of overvaluation is an integral part of the definition.
This recognition was certainly present in the weeks and months leading up to the dot-com bubble burst in March 2000. In the early to mid-1990s, you may recall, it was possible to justify higher prices. raised while keeping a straight face. But that was becoming less and less possible as prices continued to rise in the late 1990s, and more so as some dot-com companies went public with huge valuations despite the lack of assets. , income or business plan.
Rather than responding by removing a few chips from the table, many began to freely admit that a bubble was forming. They no longer tried to justify higher prices on fundamentals, but started to justify it in terms of market dynamics. Prices are expected to continue to rise as FOMO entices more and more investors to jump on the bandwagon.
Current analogies are of course not lacking. Take dogecoin, which was created as a joke and has no core value. Like a recent Wall Street Journal article describes, dogecoin “is useless and, unlike Bitcoin, faces no limit on the number of coins that exist.” Yet investors are flocking to it, for no other apparent reason than it has already grown so much. Billy Markus, the co-creator of dogecoin, was quoted in this Wall Street Journal article as saying, “This is nonsense. I haven’t seen anything like it. It’s one of those things that, once it starts going up, can keep going up.
Needless to say, things don’t go forever. Those who nevertheless continue to invest in such an environment do so with the implicit assumption that they can recognize it, in advance, when the bubble is about to burst – and therefore leave the party before everyone else. This is, however, a dangerous illusion; not everyone can be the first to leave the party.
The bottom line? Far from being a reason why a bubble does not form, the current widespread concern about a possible bubble is actually a reason to worry that it does. Take care.