5 sure-fire signs of a stock market bubble

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It seems like the stock market is hitting all-time highs just about every week in 2021. And it’s shocking to think how quickly it’s rebounded from just over a year ago when the Standard & Poor’s 500 index hit an intraday low of 2,191.86 on March 23, 2020. These days it’s blown past 4,100 – en route to a more than 90 percent gain over that time.

While stocks have shown a serious bounce since the pandemic’s start, this resilience is giving some investors pause. Could we be in a stock market bubble? Could stocks be priced so high that they’re not just overvalued but actually “hot-air-balloon-leaving-the-earth’s-atmosphere” overvalued?

Here are five signs to look for to judge whether we’re in bubble market territory and what we’ll likely see if we’re there.

Watch for these tell-tale signs of a stock market bubble

There’s an old saying on Wall Street: “No one rings a bell at the top.” It means that only in retrospect does it become obvious for most market participants that the market has hit the top.

But while there may be no bell at the top, observant investors can pick up on many indicators that show when the market is in nosebleed territory. You’ll want to see many of these factors working together to produce the euphoric bubble, as you weigh your options for how to keep your portfolio protected in the event that the hot market finally cools off — or worse, the bubble pops.

1. A story has captured the market’s imagination

A compelling story is one of the best frameworks for creating a stock bubble. The dotcom bubble of the late 1990s had one: “The internet changes everything.” The housing bubble of the 2000s had one: “Real estate never declines in price.” Even the 19th century’s railway mania promised that the massive benefits of the railroads would transform travel and transportation.

These so-called story stocks promise to transform the world, and while the promised benefits may ultimately arrive, they tend to take a lot longer than the stock promoters would have you believe.

The benefits of the internet eventually arrived, but not before effectively destroying hundreds of dotcom companies that had poor business models. And even the survivors get caught up in the frenzy, with the stocks of eventual leaders such as Amazon being bid up to astronomical levels before eventually falling along with the other stocks in the overhyped sectors.

Where we see it today: There’s not one widespread story that’s captured the imagination the way that dotcom stocks did, but a few sectors are bubblicious: electric vehicles, self-driving cars, software-as-a-service (SaaS) companies, Uber and cryptocurrency all have similar story elements that promise radical transformation and charge a very high price of admission.

2. Prices rise regardless of news

The story is important because it offers a theme to build investors’ hopes and dreams on. It also provides a guide for what’s to come and how the new transformational industry might develop. But what if reality differs from the story? Investors will surely adjust their expectations, right?

In a bubble, it’s as if every bit of information verifies the story, so stock prices rise regardless of the news. A company hits earnings estimates? The stock climbs. And if it misses earnings estimates by a mile? It still climbs. The story stocks seem unbreakable, and they are for a time.

And so sharp-eyed investors are calibrating reality to the story in order to see if they fit. When stocks rise but the long-term future looks clearly worse, long-term investors are extra careful.

Where we see it today: Stocks have climbed a lot over the past year amid the pandemic, but they’re pricing in a future recovery and in many cases are not above their pre-pandemic prices. So valuations on stocks as a whole don’t look euphoric.

But look at individual sectors or companies and you’ll see them rising to high valuations despite mediocre or poor news. For example, in December 2020 Tesla’s valuation was more than the next nine carmakers together, despite being barely profitable and facing increasing competition.

3. Other asset prices are soaring, too

Often in a bubble market it’s not just stocks that are soaring; it’s other assets, too. Flush with cash from their stock successes, a booming economy or easy money, speculators rush out to buy other highly risky assets.

During these times you may see the prices of collectibles skyrocketing. Promoters may try to hype up “new asset classes” by highlighting how investible sports cards are, or how art from the great masters never seems to decline in value. Assets such as these produce no cash flow and so turning a profit hinges entirely on finding someone else to pay more for them than you did.

And the definition of “investible” assets continues to grow: luxury handbags, shoes, Beanie Babies, wine, video game cartridges, digital art through NFTs and the list goes on and on.

Where we see it today: With thousands of possible examples, cryptocurrencies have seen a flood of interest as speculators and promoters rush to the space to cash in. NFTs are riding this wave as well. CNBC reports that cryptocurrency has a total market valuation of $2 trillion as of early April, with Bitcoin holding the lion’s share of that figure. Of course, it’s not just digital assets that have piqued interest — shoes and handbags have seen soaring prices lately, too.

4. New traders say that old investors ‘don’t get it’

When the taxi driver, the hair stylist and the grocery clerk are giving you investing tips, it’s a good sign that an investment thesis has spilled over to the mainstream and is attracting less sophisticated retail traders looking for a buck. And they may well succeed – for a period of time.

In the rush to build hype, breathless promoters will say “this time it’s different.” But it rarely is.

This new breed of trader will explain to you why Warren Buffett doesn’t “get” the new paradigm and that Buffett and other similarly “old school” investors are behind the curve. This new crowd may have been trading for just a few months, but they insist they understand the markets.

Yet it was Buffett who endured similar barbs from inexperienced traders in the dotcom bust and then came through it all. He avoided much of the housing debacle, too. Buffett was perched on a war chest and took advantage of ailing banks that needed cash and confidence during the 2008 financial crisis.

Pro gamblers love popular horse races such as the Kentucky Derby, because they bring easy money to the track, allowing the real handicappers to take it. So it is with investing, too.

Where we see it today: SaaS companies are a great example of bubbly stocks trading at nosebleed valuations. While they promised and delivered high revenue growth in 2020, they’re often not nearly so profitable (yet) to justify valuations. It’s a similar story for cryptocurrency, the Coinbase IPO, unprofitable car-hire services such as Uber and Lyft and more. Like those pro gamblers, smart investors just don’t see good odds in many similar ventures.

5. Stock valuations in the top percentiles

During the last phases of a stock bubble, the prices are all out of proportion to reality. Valuations are in the highest percentiles, as measured historically. By measuring on a relative basis, you get a better sense of how things match up to the bubbles of the past and whether a solid bull run is more likely to burst or continue, albeit with a more modest sense of “animal spirits.”

It’s important to recognize that a price rise alone is not sufficient to say something is in a bubble. A stock can rise 100 percent and not be in a bubble if its underlying fundamentals have improved significantly. Or if we start from a low valuation and then measure after a solid bull run (as we’ve seen in 2020), we’re sure to get gaudy figures that might make you think of a bubble.

However, it’s easy to cherry-pick price increases and say that we’re in a bubble, without looking at the broader context. Stocks could remain elevated for a long while as profits continue to rise.

Where we see it today: Despite the market’s strong run, stocks don’t appear clearly in a bubble, though few would call them cheap as a whole. If you extrapolate from the S&P 500’s pre-pandemic high somewhere near 3,380 in February 2020 to today’s prices (while pretending the pandemic didn’t happen), you’d find a rise of around 24 percent. That level of gain is not an egregiously good year for stocks, though it’s definitely a solid performance.

If we decide to measure off 2020’s lows, we may get an errant sense that the market is being carelessly optimistic, when it’s really being somewhat more positive than the usual year.

With all the money flowing into the economy from stimulus and the Fed, is that unreasonable?

Bottom line

When stocks are soaring it can be easy to overlook the increasing dangers posed by their valuation. It’s easy to get caught up in the euphoria, and high prices seem to lead to even higher prices. The party swirls on, until one day it doesn’t. So the world’s best investors focus on controlling their emotions as the market rises (and falls) so that they can coolly recognize when they need to buy and when they need to tread carefully.

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