- What is a stock bubble?
- Is there a stock market bubble in 2013?
I even had to look it up.
When history speaks of market bubbles, the famous ones that come to mind are:
A bubble occurs when investors put so much demand on a stock that they drive the price beyond any accurate or rational reflection of its actual worth, which should be determined by the performance of the underlying company.
- The tulip bubble – where tulip bulbs sold for as much as $60,000 today.
- The South Sea bubble – a more “conventional” bubble in a company called the South Seas Corporation. The company had no assets but claimed to have the license to mint untold riches in the South Seas.
- The Dot-Com bubble – where any company that sounded techy or had the word “Internet” in its name was instantly worth millions.
- And more recently, the housing bubble.
You will only know a bubble existed in hindsight because you cannot measure or quantify a bubble by comparing historical PEs, earnings or other metrics.
A bubble is not a rational organism.
As the market continues to march higher, are we going into bubble territory?
How to Spot a Stock Market BubbleHere’s a checklist of causes and reasons for stock market booms leading to bubbles:
- encouragement for new investors to invest due to fads and trends
- high prices in the market encourages people to see more higher prices in the near future
- economic growth sustaining corporate gains
- new opportunities created in emerging markets due to deregulation and liberalization
- more equity releases to fill investor demands
- derivatives that are new pop out and margin trading increases
- bond price increases is overtaken by share price increase
- the market being hyped up too much by people ranging from the government to small investors
- psychological feeling invulnerability by money managers with the market ‘s strong performance
- novice investors are fooled by news of incredible profits hence they buy in huge numbers
- veteran investors and fund managers are replicating high gains despite the risks
Stage 1: The Bubble Birth
At the heart of every bubble is a perfectly rational story, but the critical component in a bubble being born is the story being propagated to others in the market who want to get in on the story.
These investors continue spreading the story and exaggerate their profits. Soon, mothers, grandfathers and infants know the story and are invested in it.
Stage 2: Sustaining the Bubble
A market bubble does not burst right away. It sustains itself.
Remember when you try to blow a big balloon, you start out fast, get a little dizzy, and then as the balloon becomes bigger, you slow down the speed of blowing.
In the case of a stock market bubble, media attention, investment bankers and other institutional support hold up the bubble. So-called intellectual support makes the bubble even more believable.
Stage 3: The Bursting of the Bubble
There comes a point when no new money flows into the bubble. The market is crowded with copycats trying to take advantage of the next fool and it gets to a point where even the true believers start doubting.
With that seed of doubt and rationality planted, reality sets in and it turns into panic. The bubble has burst as investors now all rush towards the exit together.
Stage 4: The Aftermath
For most people caught in the bubble, it’s game over.
Everything is gone.
During the tulip craze, people were selling their homes to buy a piece of a tulip bulb. They became homeless overnight.
But denial remains and all of a sudden it is difficult to find people who put money into the bubble to begin with. Everybody knew the bubble existed.
These people hear the next rational story and the cycle begins.
Trying to Spot Bubbles Is Like Looking into a Crystal Ball
Using a crystal ball is hard work, because it doesn’t work.
Trying to spot a bubble is just as hard.
The problem is that everyone is a market expert nowadays. Most people will regurgitate what they hear on the news or what another person said.
“Oh, the market is still overvalued.”
“Oh, the Fed is just feeding the market.”
“Oh, they have been predicting a crash for more than four years now.”
The best thing to do is differentiate noise from fact.
Do not depend solely on single-variable analysis.
This goes back to my previous article about Warren Buffett quotes.
Think for yourself.
No matter how complicated and intricate a financial model is, you can’t trust one single metric.
Do not trust the media and Wall Street analysts.
Again, think for yourself.
Analysts are humans and also participate in bubbles.
They are prone to errors and can also be stubborn. Some of them will not budge on their predictions even when faced with overwhelming evidence to the contrary.
Watch out if your mother-in-law is suddenly an investment guru… (unless she really is one).
Small investors are always the last to get into any bubble. If your mother-in-law starts giving you hot tips, stop eating her pudding. Maybe she’ll be so shocked she will come to her senses.
But in all seriousness, no matter how disciplined you are, humans are emotional.
If you were a robot, you would be safe, but because you are emotional and human, stock market bubbles are harder to spot than you think.