Someone just said they’re worried the market might be a bit ‘frothy.’ What does that mean?

• A frothy market describes conditions where stock prices artificially increase based on market sentiment, not business fundamentals.
• Excitement and novelty are key drivers of market froth, as people invest because of fear of missing out on an opportunity to make money.
• When demand becomes too much to bear, frothy markets can lead to bubbles that eventually burst.
• Read more stories from Personal Finance Insider.

Wall Street is filled with all kinds of jargon that you’re likely to hear in news reports or conversations but might not fully understand. One such term you’ve probably heard is “frothy market.”

What is a frothy market? 

When you think of the word froth, you probably envision something like the foam that rises to the top of a mug when the beer in it is sloshed around, or the dessert recipe with instructions to whisk egg yolks and sugar into a froth.

In markets, froth is when investors get whipped up into such a frenzy that they ignore fundamentals and drive stock prices well past their intrinsic value.

“Market froth occurs when there is excitement over the development of new technologies or new products,” says Dan North, chief economist at Euler Hermes North America. “Such developments tend to make investors feel like they are getting in at the bottom floor of the next great thing, or getting a once-in-a-lifetime chance to ‘get rich quick.’ This compels investors to think that they have to buy now before anyone else hears about it, driving the price up.”

Frothy markets are highly volatile and unpredictable. The increase in prices they produce is also unsustainable. Froth often leads to market bubbles, which as history has shown eventually burst, devastating to investors and derailing the economy.

While the concept has been around for a long time, the term market froth was popularized on Wall Street around 2005, when Federal Reserve Chairman Alan Greenspan described local housing markets in the US as showing “signs of froth,” but that a ‘bubble’ in home prices for the nation as a whole” was unlikely. He got the froth part right. But Greenspan’s prediction about a bubble in home prices proved incorrect within a few years, when mortgage companies found themselves with millions of foreclosures after more than a decade of high-risk lending.

Demand for homes had increased rapidly in the frothy market as loans became more accessible to consumers, many of whom could not afford to pay them. Prices soared and a bubble was created. When homeowners began defaulting on their mortgages in large numbers, the housing market bubble burst and lenders found themselves in significant financial trouble. The ripple effect in markets and the economy pushed the US into its most severe recession since the Great Depression.

How froth works and how to spot it in the market

Overconfidence is often the driving force behind market froth. Trends, novelty, changes in market conditions, and speculation about the future value of products or technology can all lead to froth. Investors buy up shares, betting their value will increase quickly and they will be able to turn a large profit. However, these investments are not made based on business metrics that indicate the value of an asset, such as price-to-earnings ratios (PE), revenue, and cash flow.

The most common cause of market froth “is an unjustifiable level of exuberance about an asset,” says Saumen Chattopadhyay, chief investment officer at OneDigital Retirement + Wealth.

A bubble can often be an unintended consequence of monetary policies such as low interest rates or large stimulus programs, or a product in the marketplace that receives a lot of hype, Chattopadhyay says. “Usually, one or more of these factors are at play and combine with investors who either do not (or cannot) miss out on the upward returns and/or inexperienced investors who do not fully recognize the intrinsic value of a given investment asset.”

It can be hard to spot market froth in real time, but there are a few indicators that can signal these kinds of market:

1. Excessively rich valuations

Stock prices increasing to valuations never before seen without any appreciable difference in the company’s earnings, products, or services can be a sign of market froth.

This happened in 2021 when the market value of GameStop shares jumped from $2 billion to $24 billion over the course of a few days. The company hadn’t become more valuable. But a sudden huge increase in demand drove the stock price up from $18.84 per share on Dec. 30, 2020 to an all-time-high of $347.51 by Jan. 27, 2021. By Feb 18, shares were down to $40.64. The bubble had burst.  

2. Extreme investor exuberance 

One of the main drivers of the GameStop froth was extreme exuberance among retail investors to beat hedge fund investors at their own game. They banded together through social media to artificially inflate the price of GameStop’s stock so hedge funds who were betting on the value going down would lose money on short trades. 

Cryptocurrency markets also have experienced significant and rapid growth due to the novelty and excitement of this alternative to fiat money. There is no intrinsic value to cryptocurrency, only speculation as to its future value. This market has grown incredibly quickly, but has already shown it can crash just as quickly.  

3. Extended period of returns far above average

When markets or indexes show returns that are well above what they’re historically averaged, froth might be at play. For example, as the dot-com bubble began to swell between 1995 and 2000, both the Nasdaq Composite and S&P 500 delivered returns more than twice their long-term averages. We know now that tech stocks were being overinflated during this period and that’s what was reflected in these unusual returns.  

4. Media excitement about the stock market

Media outlets and analysts will report on market volatility, especially when there are huge gains being made. This information spreads far and wide, especially through social media, and helps create excitement among investors that there are opportunities to make fast, easy money, but you have to move quickly to benefit. 

“When ‘wow’ stories on newly made riches in the stock market appear on the covers of non-financial news magazines, it’s a sign of a frothy market,” says North. “When your UBER driver tells you about his stock holdings, froth is spilling over. When the UPS guy is checking stock prices as you ride with him in the elevator and he loudly announces how well he is doing in the stock market, look out below.”

Market froth before the dot-com collapse

One of the most well-known instances of market froth happened toward the end of the 20th century. The advent of the internet and ecommerce was rapidly changing the world, causing a wave of excitement among investors and venture capitalists about all the new technology coming to market. 

Investment in tech companies with ties to the internet skyrocketed between 1995 and 2000. At the time, Nasdaq listed many technology stocks, which quickly became overvalued as demand increased. Venture capitalists, lenders, and investors poured money into the sector mostly based on speculation about how the companies they invested in would do in the future, not on traditional valuation measures. 

“During the wild exuberance of the dot-com bubble from the mid 1990’s until 2000, many new technology companies did not have any earnings, or in some cases not even any sales, yet their stock prices soared,” says North. “Those valuations were based on investors’ irrational sentiment that these companies showed limitless earnings potential in an exciting new technology that would surely make them rich.”

The reality was that many of these companies were not built on sound business models and were using metrics that were disconnected from real fundamentals such as revenue, earnings, and cash flow to drive investment.

This wasn’t sustainable and the bubble this frothy market created burst when companies could not produce enough earnings. The tech Nasdaq lost 74% of its value between 2000 and 2003 and took 15 years to fully recover. The S&P 500 lost 50% of its value during this same time, and took about five years to recover.

“When these frothy bubbles burst, the results can be terribly painful,” North says.