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Jae Jun
Jae Jun
Articles (176)  | Author's Website |

The Stock Market Bubble Is Harder to Spot Than You Think

July 09, 2013 | About:
Two Questions to Ask About Stock Market Bubbles
  1. What is a stock bubble?
  2. Is there a stock market bubble in 2013?
The word bubble gets thrown around a lot without second thought. If I were to ask 10 people what a bubble was, I am confident that I would get 10 different answers. Some answers may be similar but they would not be universal.

I even had to look it up.
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.

When history speaks of market bubbles, the famous ones that come to mind are:

  • 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.
The common theme across all these bubbles is that they are irrational and contagious.

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 Bubble

Here’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
The Four Stages of Stock Market Bubbles

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.”


Just noise.

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.

About the author:

Jae Jun
Old School Value is a Stock grader, value screener and valuation tool for busy value investors.

Visit Jae Jun's Website

Rating: 4.1/5 (7 votes)


Superguru - 4 years ago    Report SPAM
1. Based on Shiller P/E chart, it would seem 25 or above is bubbly territory. Current is 24.16

2. I do not hear many people talking about buying stocks yet. I do hear that some folks are moving to cash or staying in cash
Batbeer2 premium member - 4 years ago
>> 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.

How do you know in hindsight?

Presumably because of the precipitous drop you've just witnessed.

What caused that drop?

People borrowed money to buy the assets and subsequently became forced sellers.

Invert that and you can identify and even quantify a bubble before it bursts.

Take a housing bubble. There will be a major dislocation between the price people pay for rent and the price they pay to own. If, on top of that, people are borrowing at rates far in excess of the rental yield to buy the property, then you can be sure it's a bubble. You can't be sure when it will burst though.

During the dot-com bubble, people would borrow money at 6% to buy INTC at a p/e of 50. That's a 2% yield. At some point, stock prices faltered. This created a lot of forced selling by people who had to repay their loans. Paying a 50 p/e for Intel may or may not be a good idea. That's debatable. But if people are borrowing at 6% to do it, that will definitely cause problems down the road.

In short, if 1) you see people borrowing to buy an assets and 2) they are paying interest far in excess of the expected yield of that asset, you can be sure it's a bubble.

Just some thoughts.
Dirt2624 premium member - 4 years ago
Bubbles are monetary events. When the idiots allow the growth of money and credit to rise above the 90 year average - the money tends to flow into the asset of interest at the time - the asset goes up in price which encourages others to use credit to jump on the bandwagon and the bubble grows. Eventually, the idiots that allowed money and credit to grow above its long term rate will reverse course and the bubble pops causing the asset price to crash. Watch the growth of money and credit relative to its long run average growth and watch where it flows to when the idiots step on the gas peddle. A 4 year old can do it but a PHD in Economics is blind to it.
Superguru - 4 years ago    Report SPAM
Dirt2624 - " Watch the growth of money and credit relative to its long run average growth and watch where it flows to when the idiots step on the gas peddle."

Any websites where I can find this information?

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