Five ways to spot a stock market bubble

Bubbles seem to be bursting everywhere these days, as historically low interest rates and unprecedented stimulus measures drive asset prices to skyrocketing highs.

There is a growing call for potential bubbles, including Bitcoin, American tech, Tesla, GameStop, non-fungible tokens (NFTs) and, arguably, house prices.

There is nothing new in this. History is full of bubbles, so what can the past teach us in today’s uncertain marketplace?

The bubbles tend to follow a broad pattern. Investors are excited about a new opportunity. Prices rise steadily, then soar. The expected correction does not come. Euphoria settles in, sucking up the few remaining skeptics. So… pop!

Here are five scenarios that have typically happened in previous bubbles – and are also happening today. How worried should we be?

Asset prices accelerate

Paul Jackson, global head of asset allocation research at asset manager Invesco, looked at 15 historical bubbles, from the South Sea bubble of 1720 to the Bitcoin bubble of 2013, and found a similar model at all.

“They typically involve a doubling or tripling of prices over a period of two to three years, with an acceleration in the last few months,” says Jackson.

The descent is almost a mirror image. “Once the bubble bursts, things move quickly.”

By this measure, Bitcoin is beyond a bubble. In the three years leading up to April 21, it increased almost eightfold, from $ 8,000 to $ 61,965.

There was also an acceleration in the final stages. In the past six months, it has grown six-fold, from $ 12,000 in October.

Now it’s less than $ 40,000 and, according to Mr. Jackson’s formula, it could have a lot more to drop.

He says Bitcoin is a clear bubble. Maybe an endless one. “It appears to be in a series of inflated and deflated bubbles.”

The American S&P 500 has also become gangbusters. Three years ago, on May 18, 2018, it traded at 2712. Today it stands at 4,127, up 52%. It’s fast, but it’s not Bitcoin fast.

It looks like a bubble by other measures. Shiller’s price-to-earnings ratio, which measures the cost of companies by dividing their stock price by earnings, currently stands at 36.61, more than double the S&P 500 average of 16.82.

History shows it has only been higher once before – at the height of the dot-com bubble in 2000, when it hit an all-time high of 44.19.

Worryingly, it was lower before the Black Tuesday crash on Wall Street on October 29, 1929, trading around the 30 mark.

Bubble Note: Bitcoin is a bubble (which is now bursting). The S&P 500 probably isn’t. Again.

Governments have provided significant budget support and household savings rates have risen sharply, increasing the pool of savings that can be invested in asset markets

Paul Jackson, Global Head of Asset Allocation Research, Invesco

Credit is cheap and plentiful

Another factor common to late bubbles is that credit is easy and cheap. This helps fuel higher risk behaviors, like borrowing to invest.

We are here today, with both “sufficient credit and liquidity,” says Jackson. “Central banks have cut interest rates to zero or even negative levels, and many have removed capital buffers from the banking sector.”

Governments have also tackled this when tackling the Covid-19 pandemic. “They have provided a lot of tax support and household savings rates have risen sharply, increasing the savings pool that can be invested in asset markets,” Jackson said.

In March, US stimulus measures accounted for more than a quarter of gross domestic product, amounting to about a third of Germany’s GDP and more than half for Japan.

US President Joe Biden deposited a $ 1,400 stimulus check into the bank account of any citizen earning less than $ 80,000.

This has given a boost to retailers such as online giant Amazon, but Fawad Razaqzada, market analyst at Think Markets, warns that an overstimulated market could push up inflation and interest rates, and put an end to the market. cheap money.

“Investors aren’t too worried yet, but the possibility of high inflation expectations creeping through the public will worry the Fed and the stock markets.

Bubble Note: If inflation is temporary, you will be fine. Otherwise, cover your ears.

Early adopters fan the flames

Writer Gore Vidal said, “Every time a friend is successful, something in me dies,” and so do investors.

They spend far too much time looking over their shoulders at how well other people are doing for fear of missing out.

Now known as FOMO, this habit has been particularly marked among cryptocurrency investors. For many, this is the number one reason to invest. They don’t want to kick each other forever because they’ve stood aside.

Mr. Jackson says FOMO fuels every bubble. “Early adopters stoke the flames by creating believable stories that are then heavily marketed. Eventually, even the skeptics surrender, creating the final crescendo.

Herd instinct is also at play, he says. “Nothing succeeds like success. Investors find it easier to buy something that has recently risen.”

We only hear about the winners because no one ever brags about their losses

Tim Bennett, Director of Education, Killik & Co

Our natural coping mechanisms, perfected over thousands of years, leave us prone to FOMO, says Tim Bennett, education manager at investment firm Killik & Co.

“Stock trading has become the latest craze for the crowds. On Webex and Zoom, in chat rooms and even in socially remote public places, you’ll read and hear stories about the dramatic gains made, sometimes within hours, on individual stocks. “

The temptation is clear. “We only hear about the winners because nobody ever brags about their losses,” says Bennett.

Bubble Note: Too many players are playing instead of investing. It can’t end well.

There is a good story to tell

Investors are not completely fancy. For bubble behavior to take hold, there has to be a “kernel of truth” behind it, says Jackson.

US tech stocks have a good story to sell, as companies like Apple, Amazon, Microsoft and Alphabet, which owns Google, are making real money, not just in people’s imaginations.

“Although they still rely on investors who buy in a dream of continued and strong growth in the future,” he says.

The obvious danger is that investors will get too excited and value growth that never happens.

The electric car maker Tesla is a good example. Elon Musk’s cult surged the stock price seven-fold last year, peaking at $ 880 in early January. At the time, its share price was trading at over 1,000 times earnings. The stock has been down by more than a third since then.

Even cryptocurrencies have this kernel of truth, as they have tapped into fears that the monetary authorities will lose control of the stimulus and that the resulting inflation will destroy the value of fiat currencies and other asset classes. .

Mr. Bennett says it’s hard to resist the lure of making easy money. “Why wait 20 years to make steady gains when you can double your money in one morning? Our natural impatience and relatively short attention span add fuel to the fire. “

Bubble Note: The stories get longer and longer. Perhaps the crypto crash will serve as a reminder that things don’t always end happily.

Assets grow in a straight line

According to Peter Garnry, head of equity strategy at Saxo Bank, the dominant view is another sign of a bubble for an extended period, as seen with US tech stocks and cryptos (until recently).

The problem is that long-term outperformance is sometimes justified, as seen with Amazon and cloud-based software company Salesforce.com.

“Both looked like bubble stocks 10 years ago, for different reasons, but their profitability only increased over time, so the market correctly priced these assets,” says Garnry.

Today’s stock market is not in a bubble, but there are pockets of overvaluation, he adds.

“One of the first signs of a potential bubble is a multi-fold increase in the share price with no obvious triggers such as revenue or profit growth.”

One of the first signs of a potential bubble is a multi-fold increase in the share price with no obvious triggers such as revenue or profit growth.

Peter Garnry, Head of Equity Strategy, Saxo Bank

Mr. Garnry cites zero-emission vehicle company Nikola as a recent example, which climbed more than 650% in just two months last year. “This was driven by high expectations for its technology, but subsequent events could not support the assessment.”

Mr. Jackson shares his view that the stock market is not yet in bubble ground. “Although, I think some sections are, most notably the NYSE FANG Plus Index, which tracks the world’s 10 biggest tech giants.”

Rupert Thompson, chief investment officer at Kingswood, is also confident. “Equity valuations are high, but big earnings gains mean stock prices are still ahead.”

Something common with every crash is that no one can predict when it will happen. The worst thing investors can do is sell, just in case. You can make a lot of money in the last stage of a long bull market.

Bubble Note: There is still money to be made, but now is not the time to be reckless.


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About Robert Valdivia

Robert Valdivia

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