What's a bubble? A small globule, typically hollow and light? A small body of gas within a liquid? Well, technically yes. But this is a commentary on investing, not physics.
Webster defines an investing bubble as "a state of booming economic activity (as in a stock market) that often ends in a sudden collapse." Investopeia says a Speculative Bubble is "a temporary market condition created through excessive buying, and an unfounded run-up in prices occurs." Well, by these broad definitions every single bear market is a "bubble", and even the brief correction in equities earlier this year was also a "bubble". We say both these definitions are wrong.
A true bubble is actually a psychological "mania". Webster's Dictionary says a mania is: 1: excitement manifested by mental and physical hyperactivity, disorganization of behavior, and elevation of mood; 2: excessive or unreasonable enthusiasm.
This means that investing bubbles are psychological phenomena that happen when the majority of market participants become irrational and speculate prices upward based on false reasoning…such as Technology stocks in 2000 or Energy stocks in 1980. True bubbles don't happen often because that sort of pervasive irrationality and exuberance are rare. Fear is the most common emotion in investing.
When the blinding enthusiasm ends (as it always does), the valuations go with it…putting asset prices back near levels coincident with their fundamental values. Therefore, a market by definition can't "see" a bubble as it's happening, since the broad skeptical recognition of a bubble itself would curtail the euphoria needed to blow it up.
Knowing the difference can be vital to your investing success. Don't let media misnomers allow you to be bamboozled by bogus bubbles. In fact, we dare you to say that three times fast so you remember it.
Here are a few examples of the misused term:
1. Is the Worst Over for the Housing Bust?
The Wall Street Journal
"People say all bubbles end in disaster, but this is a small bubble. Home prices are just about 20% too high. We need to take it seriously, but in the history of bubbles, this will go down as one of the smaller ones." Huh? There's no such thing as a "small" bubble. They don't have magnitude. Housing prices have had a great run based on solid economic fundamentals, not irrational speculation on the whole. That there is an ensuing period of flat or down prices for a time is common.
2. Tech Bubble 2.0?
There is simply far too much dour sentiment and skepticism out there for Tech stocks to be in a true, manic, bubble. The existence of this article alone proves it.
3. Dancing on Bubbles in a Takeover Stampede
The Washington Post
The current M&A boom is being driven by robust, cash-rich balance sheets and cheap access to capital. Most companies are actually adding to their earnings by issuing debt or using cash to buy assets at a lower cost of capital than the yield on their earnings per share. Again, not the stuff of irrationality; this is all quite rational and profit-maximizing behavior.
4. Global Population Bubble: 9 billion by 2050
We don't even know what this last one is supposed to mean.