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What is a Speculative Bubble?

A speculative bubble is more frequently referred to as an economic bubble. It describes a situation when one or more sectors of the overall stock market become overvalued.

Bullish behavior is what drives market prices above their true values. Investors become intoxicated by the lure of strong gains. They want to ride the wave high profits, expecting the growth to continue. They mainly don’t want to miss out on claiming their piece of the pie.

There are some market indicators that can hint at overvaluation. Examining individual stock sectors can provide a more targeted warning of this bubble.

One key indicator is the price-to-earnings ratio of individual stocks in a common sector. When stocks prices rise faster than earnings, the stock can become overvalued. When several stocks in the same sector become overvalued, this can be a prelude to an impending market correction. Investors commonly refer to this action as the bubble bursting. The result is a rapid decline in stock prices within that sector.

Investors witnessed the nature of this phenomenon within the real estate sector beginning in 2005. Several home builders experienced rapid growth as a result of low interest rates. Speculators snapped up both the actual properties that were rapidly increasing in price and the stocks of companies building these new homes. When interest rates increased, the housing market began to cool.

Many speculators were unable to sell their newly acquired properties, and many even sustained losses. To make matters worse, many mortgage lenders began to experience record defaults in late 2006. The high numbers of adjustable rate mortgages led to rapidly increasing mortgage payments. Many lenders sustained heavy losses due to a high number of foreclosures.

Similar to the bursting bubbles experienced in many overheated housing markets, other stock market sectors can experience overvaluation caused by bullish investment strategies. The dot com crash in the late 1990s was due to overvaluation of many technology stocks based on expected revenues that never materialized on dozens of new companies.

Whereas bullish behavior creates these speculative bubbles, bearish investment strategies tend to look for these situations. Bearish investors identify bubbles and wait for them to burst. They then invest in stocks that have been beaten down by frantic investors. They sometimes bet that this drop in price is an overcorrection, which will lead to future gains.

Speculative bubbles represent a volatile situation where gluttonous investor behavior makes that market sector highly unstable. The potential for short-term gains is offset by the high probability of an impending collapse within that sector. In many cases, the gains are not worth the risk.