Occasionally stock prices suddenly take a big increase in their price purely based on some sort of speculation. It might be an event believed to be of major impact which triggers the rise and as a result, traders begin to buy shares so as to have a share of the profits they believe will come their way. As buying volumes increase the price rises higher and bears no relation to the intrinsic value of the shares in question, and the stock becomes highly overvalued. Everyone joins in the buying spree like a herd of animals, either because they have convinced themselves that it’s a good idea or because they simply want to share in the potential profits, so everyone buys until the stock becomes extremely overbought. This is known as a Speculative Bubble or an Economy Bubble. However, the bubble is incomplete until prices come full circle and returns back to normal.
The two most recent and famous speculative bubbles have been the bubble in the 1920’s just prior to the great depression and the dot com bubble in the 1990’s. Both were fuelled by great optimism on the new technologies that were being introduced. In the 1920’s it was airplanes, cars, radio and electricity; in the 1990’s it was the coming of age of the internet and the high speed internet connections. When both these bubbles had ended thousands of investors had lost everything.
In some cases the speculative bubble is not market wide but restricted to one stock or a particular industry sector and can be very short term, as buyers raid a stock just before the announcement of a piece of major news, then no sooner is the news out, the stock trend is reversed and it begins to retrace and return to its original price. Many investors can lose a lot of money from this type of sudden market movement.
The stock market is essentially driven by psychology and psychological factors and only those traders and investors who have a thorough understanding of the psychology of speculative bubbles are able to profit in the long term.
Investors who understand speculative bubbles ready themselves to buy when the price begins to decline or retrace as it always does after such a hike. Sometimes, it does not return to exactly where it was prior to the hike, but there is always some sort of retracement. Sometimes, the simple speculation of key players either by hinting at a new stock trend about to develop or by buying large volumes of shares in a certain company or industry sector can spark a speculative bubble. It is sometimes done on purpose by the heavyweight movers and shakers in the market as they try to make some quick profits.
To survive in the stock market, you must be able to identify speculative bubbles and know just how to use it to your advantage.