What is a stock market bubble and how do I trade it?

In 1711, the South Sea Company was formed to take advantage of a monopoly on trade with the Spanish colonies of South America. Eager investors piled into the stock, with a guaranteed interest of 6%, after the company’s directors claimed that vast riches awaited. The bubble reached its height in 1720 after the UK Parliament accepted the company’s proposal to take over the national debt.

Shares in the South Sea Company surged from £128 in January 1720 to £1,050 in the summer. It was so successful that it spurred on several other similarly-themed stock companies, including some to rebuild vicarage houses and — most famously — “a company for carrying on an undertaking of great advantage, but nobody to know what it is”. The subscription for this mysterious company sold out. The South Sea bubble burst soon after. According to the UK National Archives, more than twice the amount of stock available was sold to the public, with this new money paid out to older investors.

The rapid expansion of the UK rail network in the early 1800s encouraged investors to hitch a ride on the growth of railway companies. Spurred on by the government cutting interest rates and network expansion plans, the bubble expanded until hitting the buffers in the 1840s. Both an interest rate hike and a realisation that much of the track network would never be used battered market sentiment.

Arguably the most famous of stock market bubbles. The economy soared in the 1920s following the First World War. New technologies such as aeroplanes took flight, and the construction sector boomed. More people bought shares, many on credit, to profit from the rise. However, confidence drained in 1929, causing the Wall Street Crash.

In response to a slump in 1986, the Japanese government launched a programme of monetary and financial stimulus to recharge the economy. Investors became so excited that share prices tripled between 1985 and 1989. The Nikkei index hit a high of 38,915 in December 1989. However, the bubble burst when the Bank of Japan raised interest rates. The stock market plummeted and ushered in Japan’s Lost Decade of stagnant economic growth, which began in 1991.

The growth of the internet during the 1990s sparked investor frenzy in a new wave of web-based companies. This led to a rush of, often loss-making, companies going public and achieving multi-billion-dollar valuations. According to Investopedia, the Nasdaq Composite Index, home to most of the tech or dotcom stocks, rocketed from under 500 at the start of 1995 to a peak of over 5,000 in March 2000. However, when several dotcom stocks declared bankruptcy, or it became clear that their business models were flimsy, the bubble burst, and prices plunged. However, some dotcom businesses did justify the hype, such as Amazon.

This is a classic example of a rare black swan event — something which is impossible to predict before it happens but leads to catastrophic consequences. According to the US Bureau of Labor Statistics, house prices in the US doubled between 1996 and 2006. However, much of this was fuelled by sub-prime mortgages to borrowers with poor credit scores. Financial firms sold these loans, known as mortgage-backed securities, to commercial investors. However, when the subprime borrowers defaulted on their loans, it caused a ripple effect, leading to a stock market crash and the global financial crisis of 2007-2008.

In the spring of 2015, the Shanghai stock market and the Shenzhen stock market had a combined market capitalisation of $9.5trn, making China the second-largest market in the world, according to The Guardian. The growth in share prices had been fuelled by a new group of ordinary investors, such as farmers, often buying on credit. Around 9% of Chinese households were said to have bought into the markets. However, a combination of slower economic growth and government interventions such as credit limits burst the bubble.