Stock Market Bubbles and Crashes: What do they all have in common?

Just a few months ago, a visibly scary chart was making its way around the Internet.

This chart compares the market’s gains over the last year to those leading up to the 1929 stock market crash. The two chart patterns are eerily similar:

1929 stock market crash

This next chart, however, is much less scary. This chart shows the percentage gain rather than the absolute market gain, meaning how far the market has grown within that time period.

1929 stock market crash parallel

 

Here we see that the gains over the last year are relatively much smaller than those leading up to the 1929 crash.

Phew…right?

Well, there always exists both the Bulls and the Bears, and they always have opposing views as to where the market is headed. You can always find people talking about how the market is about shoot up and others warning of its impending crash.

This post will look at some of the basics behind the bearish way of thinking, and what market bubbles and crashes really look like.

Betting on a Bubble 

In 1996, Federal Reserve chairman Alan Greenspan made a speech about rising stock market prices in which he said:

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?”

Those words, “irrational exuberance,” became Greenspan’s signature phrase. But what did he mean?

“Irrational exuberance”—

In the context of the stock market, this means enthusiasm for stocks that isn’t grounded in reality. (That’s where the “irrational” part comes in.)

Basically he was warning people that stocks were being pushed higher by people’s emotions—and not by things like their fundamental values, prospects for growth or anticipated future earnings. And that the consequences would be a big, long correction.

When investors are putting their money in things that they’re overly excited about, a bubble begins to expand. As people realize their investments aren’t based on the facts, that’s when the bubble goes pop! 

For example, some bearish thinkers believe we are currently living in a social media bubble, where people are over-exaggerating how much social media stocks like Facebook, Twitter, and LinkedIn will grow.

social media stocks

You Don’t Need a Stock Market to Create a Market Bubble

Mark Twain said, “History doesn’t repeat itself, but it does rhyme.”

Bubbles didn’t start when we started investing in stocks. They’ve been going on for way longer than that.

All you really need is a commodity of any kind, and a ton of “irrational exuberance”. For example, this happened way back in the 17th Century…with flowers.

The Dutch Tulip Mania Bubble

Yes, you read that right: tulip mania. Back in 17th century Holland—the richest country in the world at the time—the merchant class was growing incredibly rich from trade with the East Indies. Like rich people everywhere, they wanted to show off their wealth to the rest of the world. So naturally they went into tulips.

tulip mania market bubbleNow this is not as crazy as it sounds. The rich actually were building big new estates with their money, and they bought tulips to decorate their gardens. Tulips were rare flowers at the time, and they also came in a huge number of varieties. Most important of all, it takes a long time to cultivate a flower from a tulip bulb (sometimes more than a decade), which only makes tulips that much rarer.

So, lots of new money, lots of people trying to show off their status, and a very rare commodity—the perfect storm for an bubble. And what a bubble it was.

At the bubble’s height, a single tulip bulb could sell for ten times the annual salary of a skilled craftsman. There were even futures contracts for tulips, in which people paid for bulbs that would be delivered to them months later. Bulbs sometimes changed hands as often as 10 times a day, as people tried to get rich quick.

Dutch Tulip bubble and crash

Inevitably, it didn’t last. In February 1637 prices for tulip bulbs collapsed by over 99%. Now it may have just been tulips, but when any commodity drops by 99% that quickly, it sure meets the definition of “trade at prices that are consistent with intrinsic values”.

So whether its stocks or tulip flowers, market bubbles (and inevitable crashes) can and will occur when people experience “irrational exuberance” and overvalue assets.

To learn more about evaluating assets such as stocks, check out the Definitive Coursepack on “Evaluating a Business”.

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