WHAT IS STOCK MARKET BUBBLE?
The market bubble is the phenomenon where the prices of the share of the companies does not reflect the true and fundamental position of the company and hence there is a divide between the real economy and the financial economy caused either due to herd mentality or due to irrational exuberance of the market participants or any other similar reason. In this situation, the share prices are inflated and can not be supported by the actual performance of the entity and its profits.
DEFINITION AND EXPLANATION
The prices of shares traded on the exchange get affected by various reasons such as the introduction of a liberal regulation or expansionary measures by the country’s central bank such as the decrease in the rate of policy by the federal reserve. Such measures encourage people to take out money from FDs and invest the same in the equity market in the expectation to gain higher returns. It is expected that due to such changes in policy, the companies would perform better and hence their shares will go up and rise.
Such expectations might not always be parallel and aligned with the actual economic activity that is taking place in the economy in reality because these measures at times are not able to boost the economy as much as possible. Nevertheless, such market information is not always efficient. This implies that the price does not convey all the information and details that are publicly or privately available.
WORKING OF A BUBBLE
1. Disruptive Innovations:
Internet technology was completely new tech that will revamp the way the world functioned. It looked highly promising and hence a lot of companies entered this domain during the period 1990 to 1997 to profit from the new industry prospects.
2. The Boom!
Several entities saw an initial level of success and the investors started flowing in the money in expectation of higher returns. This attracted even more companies into this sector who might not have had the capabilities to give a solid and strong performance but were dragged by the booming sector. Furthermore the tax reforms and cheaper availability of credit encouraged these companies to enter the new market and therefore the era of IPOs came.
3. Irrational Exuberance
At this point of time, the investor loses perspective of performance and keeps pouring money without realising that the entities are not doing their bit and hence the promising returns might not occur at all. This led to a great gap and divide between performance and returns expected and inflated prices of stock.
4. Panic
Globally the markets started witnessing such instances and by this stage, several investors saw their funds and wealth eroding and joined the selling spree. Investors started selling at whatever price possible to save their necks. This was the time when the bubble burst and led to the crash of the market.
CAUSES OF THE STOCK MARKET BUBBLE
1. Cheap Credit:
When the loans are available at comparatively low interest rates and the central banks are still on rate cutting spree then it is bound to lead a boom in the NPA in the times to come because the cheap credit is borrowed even by those who do not have any intention or will to actually pay it back. Hence, such borrowers are forced to sell assets and this will lead to a reduction in production capacity, thereby signalling a weaker economy and so share prices will start falling.
2. Wild Speculations:
It is one of the most significant reasons that lead to market bubbles because this is the reason why the gorge between the real and financial economy widens. When the market participants are not ready to accept the challenges that the real economy is facing and are still purchasing the stocks that are underperforming in an expectation that they will gain when these companies perform well, it leads to inflation in the prices of shares and leads to bubble creation.
3. Political Risks:
When the geopolitical risks go up and people start feeling unsafe in the country, the markets initiate dipping and if necessary measures are not timely taken the crash is evident and becomes inevitable.
4. Panic:
When the investors start realising that the financial economy is about to go down and crash, the panic selling begins, people start booking profits or limiting losses, leading to falling in the prices and this initiates the economic crash and a time comes when some shares cannot find buyers at even the lowest prices.
