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Economy 101: Stock Market Bubbles and Crashes

Ever since the 17th century, when frenzied Dutch speculators drove the price of a single tulip far above a skilled workerís annual income and practically bankrupted Holland, investors have succumbed periodically to a "bubble" mentality: Thatís where assets rapidly rise in cost far above their true value, only to later devalue (or "pop") when cooler heads prevail. (Read a fascinating account of "Tulipmania.")

Economists define a bubble as an economic cycle characterized by rapid expansion, followed by a contraction. In simpler terms, itís an overheated market (whether it be stocks, bonds, real estate, commodities, technology, etc.) where too many investors become overly eager to buy. As more and more investors enter the market, thinking that they too can profit from the run-up, inventory becomes scarce and as a result, prices rise too quickly to be justified or supported by an objective analysis of the underlying value of the company or asset.

Eventually, some investors – often those who got in on the ground floor of the boom – recognize that the rising trend is unsustainable and start selling off. Other investors quickly catch on and start dumping their shares or assets, hoping to salvage their investments as well. But, because fewer people want to buy into a declining market, prices plunge and those who entered the game late often suffer substantial losses. In short, as the market begins correcting itself, the bubble deflates – or in more extreme cases, it bursts.

Economists and social scientists have many theories for why bubbles occur. Many agree that although attractive fundamentals (or the perception of them) underlying the asset may initially drive prices higher, eventually a sort of herd mentality takes over – people donít want to miss the boat on high returns being reaped by others. A similar stampede occurs on the downswing.

Often, when an investment class becomes overheated to the point where prices cannot be justified by underlying value, the market undergoes a correction, usually at least a 10 percent decline. In more extreme cases, the devaluation may trigger a market crash, which is a much more significant and sustained drop in the total value of the market (usually 20 percent or more), causing massive losses and a much slower recovery.

The underlying causes of a bubble can be extremely complex. For example, in the recent housing bubble, many simultaneous factors were at play, including:

  • Interest rates had remained artificially low after the recession of the early 2000s in an effort by the Federal Reserve Bank to keep the overall economy strong.
  • Homebuyer credit borrowing standards became increasingly relaxed, so people who previously couldnít afford homes entered the market in droves.
  • Inventory became scarce, further driving up costs and fueling overdevelopment in "hot" investment markets.
  • Real estate speculators took advantage of easy credit to overextend themselves, hoping to make a killing in the market.
  • Many people used their overvalued homes as piggybanks to withdraw money for discretionary purchases or to invest in additional real estate, further stretching their ability to make mortgage payments.
  • Many mortgages, including subprime ones, were lumped together and sold as highly rated securities to investors.

Prices, whether of shares of stock, tulips or real estate, eventually bottom out and begin to normalize in value. At that point, investors looking for a place to invest their funds and once again make a profit, cautiously reenter the market – hopefully having learned from the speculative furor that caused the bubble to inflate and burst. In the case of housing, some areas of the country have begun a slow recovery, while others are still shaking out.

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