How does a market bubble develop?

Although every bubble is different, many follow a similar pattern, moving from an initial opportunity to growing optimism, heightened speculation and, potentially, a sharp reversal. The process can be broken into six stages. There is no fixed timetable, and some markets may skip stages or move between them. However, the framework offers a useful way to understand how prices and investor expectations can become disconnected.

Stage 1: Displacement. A new opportunity emerges

Most bubbles begin with a significant change, whether that is a technological breakthrough, lower interest rates, a new industry or a shift in government policy. Initially, the excitement may be justified because investors are responding to a genuine opportunity with the potential to change how businesses operate and generate revenue.

Consider AI. The expansion of generative AI has increased demand for computing infrastructure, while Nvidia supplies chips and systems used to train and run AI models. Its position within this investment cycle has attracted considerable attention from investors. At this early stage, rising valuations are not necessarily irrational. The question is whether expectations remain proportionate to the growth opportunity.

Stage 2: The boom. Fundamentals support rising prices

As the opportunity becomes clearer, more investors enter the market, supported by improving company results, positive earnings expectations and increased institutional interest. Strong fundamentals can reinforce the upward trend, and that is what makes this stage difficult to distinguish from the beginning of a potential bubble. Sometimes, an impressive share-price performance is backed by an equally impressive business.

Nvidia provides a useful example. In its second-quarter fiscal 2027 results, released on 26 August 2026, the company reported revenue of US$96.2 billion, up 106% from a year earlier. Data centre revenue reached US$89.0 billion, an increase of 117%. These are reported business results rather than simply expectations of future demand, which complicates any attempt to label Nvidia's share-price performance a bubble.

However, even exceptional earnings growth does not automatically make every valuation reasonable. The important question is how much future success investors have already priced in.

Stage 3: Momentum. The story starts driving the price

As prices continue rising, market psychology can begin to change. Investors who were previously sceptical may reconsider, while growing media coverage, social media discussions and success stories attract new participants. The fear of missing out (FOMO) becomes more prominent, and the trade can begin to look increasingly crowded, while attention can gradually shift from what a company is earning today to how much its shares might rise tomorrow.

In the AI sector, this could mean investors treating companies associated with the technology as potential winners, even when their revenue, profitability and competitive positions differ substantially. An AI connection alone does not guarantee commercial success, although during periods of heightened enthusiasm, the label can start doing an impressive amount of heavy lifting.

This is where valuation assumptions, market participation and the quality of underlying earnings become particularly important.

When does enthusiasm become a warning sign?

The next three stages illustrate how optimism can develop into speculation and what may happen when market expectations begin to change.

Stage 4: Euphoria. Expectations become increasingly difficult to meet

In the later stages of a potential bubble, price increases may accelerate, pullbacks can become shorter and investors may begin assuming that the upward trend will continue indefinitely. Traditional valuation measures receive less attention, while phrases such as 'this time is different' and 'the old rules no longer apply' become increasingly common. Apparently, even the balance sheet can take a back seat when the story is exciting enough.

For Nvidia and the wider AI sector, the underlying question is whether infrastructure spending can continue growing quickly enough to support elevated expectations. Companies investing heavily in AI must eventually assess the financial returns from that spending. A Reuters analysis published in July 2026 highlighted the pressure that expanding AI capital expenditure could place on major technology companies' free cash flow.

Continued investment could support demand for Nvidia's products, while slower spending, margin pressure or weaker-than-expected results could challenge market expectations. None of this establishes that Nvidia is in a bubble. It simply highlights how future growth assumptions become increasingly important when valuations are elevated.

Stage 5: The reversal. Expectations meet reality

A bubble does not necessarily reverse because the underlying technology fails. Sometimes, businesses continue growing, but not as quickly as investors expected. An earnings disappointment, reduced guidance, tighter credit conditions or a change in sentiment may prompt investors to reconsider how much they are willing to pay. As confidence weakens, the same momentum that helped push prices higher can begin working in reverse.

Leverage may amplify the decline as falling prices trigger margin calls and forced selling, potentially creating further volatility. For Nvidia, a hypothetical slowdown in AI infrastructure spending could put pressure on market expectations, even if the company remains profitable and continues generating substantial revenue.

A strong business is not automatically a strong investment at every price. Unfortunately, the market does not award bonus points for being right about the technology if the valuation was wrong.

Stage 6: The aftermath. Prices and fundamentals reconnect

Following a major reversal, enthusiasm may give way to scepticism as speculative participants exit, valuations adjust and investors return their attention to earnings, cash flow and sustainable growth. Some companies may struggle to recover, while others could continue expanding and eventually justify renewed investor interest. The underlying technology may still reshape entire industries, even if some of the companies associated with it were previously overvalued.

That distinction matters for AI. A correction in AI-related shares would not necessarily mean the technology has failed, just as continued AI adoption would not guarantee rising share prices.

Bubble or overvalued? The key differences

Not every expensive stock is in a bubble, and high valuations can sometimes be supported by strong earnings growth, genuine competitive advantages or expectations of sustained profitability. The warning signs become more concerning when prices increasingly depend on optimistic assumptions rather than measurable business performance.

These characteristics are indicators rather than a checklist that can deliver a definitive answer. Markets can remain expensive for extended periods, while genuine growth and speculative behaviour may occur simultaneously. For Nvidia, the distinction comes down to the relationship between business performance and the expectations reflected in its share price. Strong earnings provide fundamental support, but future growth, margins, competition and customer spending remain important considerations.

What to watch next in Nvidia and the AI market

The question is not simply whether AI is experiencing a bubble, but whether business performance can continue supporting the expectations reflected in market prices.

None of these signals can identify a bubble with certainty. Together, however, they may help distinguish a fundamentally supported rally from one becoming more dependent on speculative enthusiasm.

The bottom line

The AI bubble debate is ultimately a valuation question. Nvidia has real revenue, real demand and a central role in AI infrastructure, but the risk grows when prices require near-perfect execution and increasingly optimistic returns on that spending.

Recent scrutiny around Jensen Huang adds a separate leadership and governance risk. It does not erase Nvidia's fundamentals, but it can affect confidence, sentiment and the valuation investors are willing to pay.

For traders, the practical task is not to call the exact top. It is to watch where fundamentals, expectations and sentiment begin to separate.