Between November 1636 and February 1637, the price of tulip bulbs in the Netherlands increased more than a hundredfold, reaching a value equivalent today to tens of thousands of dollars per bulb. But on February 3, 1637, it became clear that no one was willing to buy bulbs at such prices anymore, and prices began to plummet sharply. By May 1, prices had already dropped more than a hundredfold, returning to the levels seen in 1636, and the decline continued. These events marked one of the most famous financial crises in history—the speculative bubble known as Tulip Mania.
Since then, many bubbles have burst, and economists now face the challenge of detecting them in time. Researchers have developed numerous methods, but all have significant drawbacks, and speculative bubbles continue to form and burst even today. This article will discuss the main approaches to identifying speculative bubbles.
Contents
- What is a speculative bubble
- Mechanism of bubble formation
- Phases of speculative bubble development
- Methods for detecting speculative bubbles
- Economic methods
- Technical analysis methods
- Can you profit from a bubble
What Is a Speculative Bubble
Before searching for something, it’s important to understand what we’re looking for.
A speculative bubble is a significant deviation of an asset’s market value from its intrinsic value.
Intrinsic value is the value of an asset calculated based on the expected future income it will generate and the risks associated with those returns. Since no one can know the future with certainty, intrinsic value is somewhat illusory. It can be estimated, but we can never be sure our estimate is correct.
In a way, this is similar to weather forecasting. The forecast for tomorrow, like the estimate of intrinsic value, exists today and determines our current behavior: whether we prepare for snow and take out our coats, or expect heat and keep wearing shorts. However, today we cannot definitively say how accurate the forecast is (whether there’s a bubble or not); that will only become clear tomorrow.
Mechanism of Bubble Formation
A speculative bubble does not appear instantly—it arises from a combination of optimism, new ideas, and the desire to be first. It starts with a small group of participants who see potential in an asset: a technological breakthrough, a new raw material, an unusual financial instrument, or simply a compelling story for growth. Prices begin to rise, and early successes attract wider attention.
Gradually, crowd psychology comes into play. Participants stop evaluating fundamental value and start relying on emotions: “If it’s rising, it will keep rising.” The FOMO effect—fear of missing out—emerges. Prices rise not because the asset has become more valuable, but because interest is growing. Each new buyer pushes the market higher, reinforcing the illusion of stability.
When expectations become more important than real data, the bubble enters a phase of accelerated growth. People buy not the asset, but the dream of easy profit. At this point, the market is most vulnerable—everything rests on belief, not facts.
Phases of Speculative Bubble Development
Every bubble goes through the same stages, regardless of era or asset type. First, “smart money”—professionals—enters the market, noticing the new phenomenon at the earliest stages, before the news reaches the mass media. Next, early adopters join: investors who follow trends and are ready to take risks for the sake of potential gains.
When information reaches the broader public, rapid growth begins. Newcomers enter the market, seeing only the rising chart and ignoring fundamental risks. This stage is accompanied by intense media euphoria: forecasts become bolder, criticism weaker.
The peak of the bubble is the moment when expectations outweigh reality so much that the price can no longer sustain its trajectory. After that, everything happens quickly: initial doubts trigger a wave of selling, the crowd panics, liquidity vanishes, and the bubble collapses much faster than it grew. The crash seems sudden, but in reality, it’s the logical conclusion of a long process.
Methods for Detecting Speculative Bubbles
All methods fall into two categories, depending on how they address the fundamental challenge of detecting speculative bubbles. We’ll call them economic methods and technical analysis methods.
Economic Methods
Economic methods follow the most straightforward path for bubble detection. They try to estimate an asset’s intrinsic value in various ways and, by comparing it to the market value, identify a bubble.
For example, to detect a speculative bubble in a company’s stock market, we forecast the company’s future dividends and assess future risks. With these forecasts, we can estimate the stock’s intrinsic value. If the current market value is much higher than the calculated intrinsic value, we can say a bubble exists. Obviously, our conclusion will be more accurate the more precise our forecast is. However, this can only be confirmed after the fact.
Technical Analysis Methods
When using technical analysis methods, researchers explicitly avoid seeking intrinsic value. They believe that all possible and necessary information is already reflected in the asset’s market value. Therefore, they do not look for bubbles in the way described above. Supporters of technical analysis look for sharp price drops in the asset, assuming that observing and analyzing market value alone is sufficient to identify a speculative bubble.
For example, there is evidence that during a bubble, price dynamics often resemble an exponential curve. Thus, to detect a speculative bubble, one needs to spot such a pattern in the dynamics of market prices.
Many economists are skeptical of these methods because they lack theoretical grounding. However, this does not prevent their widespread use. Supporters of technical analysis argue that human behavior, not theory, is what matters most.
Can You Profit from a Bubble
Yes, but it’s harder than it seems. Profiting from a bubble is only possible if you understand which phase of the cycle you’re in. Early participants gain the most, while latecomers almost always lose. The problem is that everyone thinks they’re smarter than the crowd and believes they’ll exit in time.
In practice, hedge funds and professionals often participate in bubbles, but strictly by the rules: they know growth cannot last forever, so they lock in profits before the final wave of euphoria. Beginners, on the other hand, try to stay until the end, hoping for a miracle, and end up caught in the crash.
It is also possible to profit from a bubble’s collapse through short positions. But this requires high precision, experience, and emotional resilience, as the market can remain irrational longer than a trader can remain solvent.
Profits in bubbles are always possible, but only for those who understand their mechanics and can manage risk. For everyone else, a bubble is a fascinating story that ends the same way: too late and too painfully.
