8
Stock Market Bubbles
If the most sophisticated investors drive share prices, are there stock market bubbles and, if so, why do they occur? The short answer is that yes there are bubbles, but they're generally confined to industry sectors, not the entire market. And they occur because sophisticated investors are sometimes unable to offset the behavior of less rational investors.
It's important to first distinguish between stock market bubbles, bubbles in other assets, and financial crises. The stock market is unique because its underlying assets generate a stream of profit and cash flow; therefore, these assets have intrinsic value. On the other hand, most traded nonfinancial assets—like art, classic cars, and stamps—have no intrinsic value; their value is purely driven by the interaction of buyers and sellers.
The Dutch tulip bubble in 1636–1637 is one of the most talked about and controversial bubbles. Even though tulip bulbs have minimal intrinsic value, bulb prices for some rare varieties in 1636–1637 reached the equivalent of €25,000 for a single bulb. Traders bought and sold bulbs and futures contracts on bulbs based solely on their expectation that prices would continue to increase, expecting they could quickly resell the bulb or the contract to someone else for a handsome profit. Once traders realized that there weren't enough new buyers to keep increasing prices, the prices collapsed within just a few months.
It's difficult to analyze such bubbles because there is no ...
