Echo Bubble: What It Means, How it Works

What Is an Echo Bubble?

An echo bubble is a post-bubble market rally that results in another, smaller bubble. The echo bubble occurs in the sector or market in which the preceding bubble was most prominent, but the echo bubble is less inflated and thus, if it also bursts or deflates, will leave relatively less damage behind.

An echo bubble may also be observed during a false bottom or a dead-cat bounce.

Understanding Echo Bubbles

An echo bubble occurs when prices undergo a temporary, premature rally before the correction has fully run its course and washed out the overexuberant or excessive support for prices in the original bubble. It can be thought of as a kind of false bottom to the bust, which gives way to a stronger, longer-term downward trend. An echo bubble may also colloquially be referred to as a dead-cat bounce, because even a dead cat will bounce if you drop it from high enough. 

Echo bubbles may result from the same speculative, psychological, or economic factors that drove the initial bubble. Investors may mistakenly believe that the bust is just a temporary lull and try to buy the dip. Expansionary monetary policy might provide a temporary jolt to prices but be unable to prevent the ultimate liquidation of investments not grounded in sound economic fundamentals. Despite their smaller magnitude, echo bubbles can greatly intensify negative sentiment and pessimism in markets as they burst and reveal greater damage than market participants may have originally perceived. 

Identifying Echo Bubbles

Nobel Prize recipient Vernon Smith identified the occurrence of echo bubbles in laboratory experiments where test subjects bid on the price of an asset. He found that his experiments could reliably reproduce asset price bubbles, with participants frequently bidding prices up significantly higher than the fundamental values implied by the design of the experiment. When he repeated the experiment with the same subjects, another, weaker bubble would often occur. This secondary bubble was dubbed an echo bubble. Since Smith's research, economists have documented echo bubbles in numerous market episodes throughout history.  

One of the first known echo bubbles was the rally that occurred after the Great Crash of 1929. Following the market crash in the fall of 1929, the U.S. stock market rallied in the first two quarters of 1930, regaining 50% of its total value. However, just like its more memorable predecessor, the smaller echo bubble burst in short order, giving way to the Great Depression. 

Special Considerations

There is currently much debate surrounding two possible echo bubbles in the works today. There are market observers who believe that an echo bubble has formed in the housing market. Others argue that technology companies are being granted bubble valuations along with legitimately profitable innovations in new technologies. However, the timing suggests that technically these are not echo bubbles at all, give it's been well over ten years since the housing bubble of the mid-2000s and 20 years since the Dotcom bubble of the late 1990s.

Despite hype in the business media and commentary, these can hardly be considered echoes, though they may be bubbles in their own right.