The Speculative Bubble: 3 Examples From US Markets

This article is an excerpt from the Shortform book guide to "Irrational Exuberance" by Robert J. Shiller. Shortform has the world's best summaries and analyses of books you should be reading.

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What does a speculative bubble look like? What are some examples of speculative bubbles?

Speculative bubble examples can be found in US stock, housing, and bond markets throughout history. If you know what a speculative bubble looks like, you can help prevent stock market crashes in the future.

Learn what a speculative bubble is from these three examples.

Speculative Bubbles in Investing Markets

A speculative bubble arises whenever news about an asset’s price increase generates further price increases as investors learn about the initial increase and become overly optimistic. These subsequent increases are a byproduct of investors’ zeal about previous increases rather than a result of concrete information about the asset’s true value. 

(Shortform note: According to economist Hyman Minsky, the lifespan of speculative bubbles has five key stages. First, investors become optimistic because of some financial development, such as a new product release. Then, prices start to rise as more people invest to avoid missing the boom. Afterward, momentum carries prices even higher, and some investors decide to cash out because they believe the bubble is about to burst. Finally, other investors begin to panic as the price begins to drop, spurring widespread selling that effectively bursts the bubble.)

We’ll dig deeper into the rationale for thinking that speculative bubbles occasionally take root in the US stock, housing, and bond markets. In each of these markets, we witness price increases that aren’t justified by concrete economic developments and therefore must stem from speculation.

1. Speculation in the US Stock Market

To show how speculative bubbles affect stock markets, let’s examine the dotcom boom in the late 1990s, during which sharp increases in stock prices outstripped companies’ economic gains and price-earnings ratios soared to record highs.

The dotcom boom was the culmination of 18 years of unprecedented growth in the US stock market between July 1982 and August 2000. Between these dates, the US stock market increased 7.7-fold when adjusted for inflation. Moreover, between 1994 and 2000 alone, the stock market tripled in value. This increase should have been accompanied by proportionate economic growth if it wasn’t the product of a speculative bubble. But no such growth occurred: Between 1994 and 2000, for example, US corporate profits increased only 60% and the gross domestic product (GDP) increased 40%, even though stock prices tripled in that same timeframe. 

(Shortform note: Historically, the S&P 500 has had a strong positive correlation with US GDP. According to experts, the correlation between the two was 0.958 (on a scale from -1 to +1) between 1960 and 2020, meaning that variation in the S&P 500 was very closely linked with variation in US GDP in this timeframe. Viewed through this lens, the disparity between the growth of the S&P 500 and US GDP between 1994 and 2000 is especially anomalous.)

As further evidence of a speculative bubble, we can look at the S&P 500’s cyclically adjusted price-earnings ratios (CAPE ratios) in 2000. CAPE ratios, he explains, are equal to a stock index’s current market price divided by its average inflation-adjusted earnings per share over the last 10 years. For example, in June 2021, the S&P 500 was priced at $4,259 and the average inflation-adjusted earnings per share was $116, meaning that the CAPE ratio was 36.7 (because 4,259 divided by 116 equals 36.7). More simply, CAPE ratios provide a measure of how much investors are willing to pay for each dollar that companies earn. If they’re willing to pay more for each dollar of earnings, that suggests a higher degree of speculation.

(Shortform note: CAPE ratios are a modification of standard price-earnings (P/E) ratios—a company’s share price divided by its earnings per share over the previous year. CAPE ratios have two advantages over standard P/E ratios: First, by considering the share price over the past 10 years, they smooth out sharp fluctuations that occur on a yearly basis, and second, they ensure that years with abnormal inflation rates don’t lead to distorted P/E ratios.)

On March 24, 2000, the S&P 500’s CAPE ratio hit 47.2, which was an all-time high. This record high indicates that stock market investors were paying unprecedented stock prices relative to companies’ earnings, a surefire sign of speculative trading. Because of this unparalleled CAPE ratio, the dotcom boom was considered a speculative bubble—one that burst shortly thereafter, with the S&P 500 losing about half of its value by 2003.

(Shortform note: For context, the S&P 500’s average CAPE ratio since 1950 has been 20.2 with a standard deviation of about 8. As of September 2023, the S&P 500’s CAPE ratio remains above-average at 31, suggesting that the stock market may still be overvalued because of high speculation.)

The Speculative Bubble: 3 Examples From US Markets

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Here's what you'll find in our full Irrational Exuberance summary:

  • That financial markets are rife with speculation
  • The three key US financial markets where speculative bubbles have formed
  • Recommendations to financial leaders and the public for mitigating bubbles

Becca King

Becca’s love for reading began with mysteries and historical fiction, and it grew into a love for nonfiction history and more. Becca studied journalism as a graduate student at Ohio University while getting their feet wet writing at local newspapers, and now enjoys blogging about all things nonfiction, from science to history to practical advice for daily living.

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