“Excess generally causes reaction, and produces a change in the opposite direction, whether it be in the seasons, or in individuals, or in governments.”
Plato (427 – 347 BC)
A financial mania, like any aberrant and self-destructive group activity, grows as new entrants and the passing of time legitimize the activity.
Much research demonstrates this dynamic of human behavior, and have concluded that in a crowd, individuals take the inaction or action of others as a cue that this is the right course.
It is no revelation to apply this concept to group dynamics and in financial manias. Charles MacKay (1814 – 1899) in his 1841 “Extraordinary Popular Delusions and The Madness Of Crowds” book observed that:
“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”
A bubble is used to describe a stock that is trading at a price above its fundamental value!
Typically, the fundamental value of a stock is equal to the present discounted value of the stream of dividends paid by the stock.
Basically, it’s the amount of money that you can expect to get back from the stock if you hold it into the distant future – taking into account the fact that present money is worth more today than tomorrow.
Things like a healthy economy, growing profit margins, a growing consumer base, etc., lead to better fundamentals and a higher stock price.
Recently a growing number of stocks do not pay regular (or any) dividends. The best way to think about the fundamental value of a stock for these cases is to think of the value of the company as the price it would receive should it be sold at some point in time.
So, why does a bubble’s price stay above its fundamental value once it’s there?
This is because if there is a bubble that has some chance of “bursting” — or have its price drop significantly — investors will not be willing to hold the stock unless there is a high rate of return.
As the price rises, the loss of money due to a fall becomes even greater, causing the price to rise even faster! The price rise will continue to accelerate until the price falls back to its fundamental level.
Why the price is initially too high is a big and strange question! It could simply arise from valuation mistakes, irrational expectations, animal mentality, or other idiosyncratic habits.
A quickly rising price reflects either a legitimate increase in the future earnings of the company, or a stock bubble — which case it is cannot be told from current information.
The fundamental price of a stock should depend only on the future performance of the company. We can only observe the price, but not the future — at least not without a crystal ball!
People are wrong about their bubble predictions all the time!
Even after the fact, a large fall in the price could be either due to a bubble bursting, or due to bad news which reduced the estimates of future performance and lowered the fundamental price.
A bubble can be perfectly rational in the sense that everyone is making reasonable decisions. The investors simply demand a higher rate of return on stocks that face a risk of bursting. Bubbles are not necessarily irrational.
On the other side, a stock that follows an irrational behavior may be priced exactly according to fundamentals — e.g. perceived future dividends; but may be completely irrational in the sense that the perceptions are too high!
In this case the prices are too high — not because of a bubble, but…
Because of mistaken expectations of the future!