Investing in the stock market can be a volatile experience over the short term. While day-to-day movements are rarely large, there are dramatic corrections or even crashes where the market falls by 10%, 20% or even more in a short period of time. In fact, these types of major selloffs occur with some level of regularity. On average, a 10% correction will hit the market averages about once per year, while a 20% or greater “crash” occurs about every three years. While long-term investors shouldn’t be afraid of these setbacks, which have thus far always been temporary, there are some signs that indicate you should perhaps proceed with caution. Here’s a look at some of the most common signs of a market bubble that may lead to a crash.
Last updated: June 24, 2021
The very nature of the stock market always draws speculators looking to make a quick buck. However, speculation reaches a fever pitch during market bubbles. Signs of rampant speculation in the market include formerly “under-the-radar” stocks that have huge increases in volume and price, the rising popularity of so-called “penny stocks” and increased chatter from dubious sources like message boards and stock touts.
Stocks Go Up Even on Bad News
In a “normal” market setting, stocks rise when they release good news — like upside earnings surprises — and fall when they disappoint investors. However, when markets are in a bubble, investors tend to buy stocks no matter what type of news comes out. In this type of environment, investors tend to make excuses for any company shortfalls and instead remain optimistic about future performance. In other words, in a raging bull market that’s a bubble, stocks tend to go up no matter what the news is.
“Story” Stocks Abound
A “story” stock is one that has no earnings and is priced at stratospheric levels based on the story that investors tell about future profitability. Typically, story stocks ride a wave of investor enthusiasm and hype based on hopes and dreams that never come true. Eventually, investors become disillusioned and a tremendous crash results.
It’s important to note, however, that some story stocks actually do work out over time when their potential is actually realized. Tesla is a great example of this. For years, the company was kept alive by investors hoping that the company would transform the automobile industry with its electric vehicles. While there’s certainly still a lot of speculators in Tesla stock, there’s no denying its success in reshaping the landscape of the automobile industry. Just remember that for every Tesla, there are likely 100 or more story stocks that fail.
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Pundits Say “It’s Different This Time”
One of the most often-quoted harbingers of doom in the stock market is the expression “it’s different this time.” It’s human nature to think that as the market evolves, so do trading mechanisms, valuation standards and investment methods. While there are certainly technological advances and other changes that are introduced as the market ages, some time-tested principles never go away. Those who predict that things are different this time tend to help inflate market bubbles, and ultimately, most of those pundits are proven wrong.
Investors Dismiss Old-Time Market Wisdom
A corollary of the “it’s different this time” bubble indicator occurs when investors reject “old-time” market wisdom and instead invest in a “new paradigm.” Evidence of this sign is everywhere in today’s market, as “meme stock” and message board mania hit all-time highs. These types of investors discount old-time valuation methods like P/E and instead focus on names they can drive higher through collective action.
In addition to stocks like GameStop and AMC Entertainment, which have shot up to stratospheric levels in 2021, these investors have also been piling into cryptocurrencies that most people have never heard of. Certainly, many of these traders have earned staggering sums as these names have skyrocketed. However, a large number are also deep in the red, and some pundits say the true crash in these types of names and cryptos has yet to come.
Valuations at Record-High Levels
Stock valuation is always a tricky thing, as one person’s idea of “overvalued” is another’s bargain. Yet, there are many traditional valuation methods that you can use to see if the market overall may be getting ahead of itself. Many investors use measures like price-to-earnings ratio and price-to-sales ratio, while others are fond of the Shiller P/E ratio. Whatever valuation method you use, be sure to consider external factors that might affect valuation, such as interest rates. If all of your valuation measures are well above historical norms, you’re likely looking at a market bubble.
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High Levels of Margin Debt
Margin debt is another tool that can drive stock speculation up to bubble levels. When investors trade on margin, they borrow money from a securities firm so they can buy additional shares. This leverage works both ways. When stocks are going higher, investors earn a higher-percentage return on their funds. However, when stocks turn lower, investors can be completely wiped out. High levels of margin debt add more dollars to the investment pool chasing stocks, which can accelerate their rise to bubble levels.
High Levels of Complacency
Perhaps surprisingly, market crashes are more likely to occur when investors are happy and complacent with the market, rather than when they are fearful of a crash. When investors feel the market will continue to go higher, they tend to invest more of their money. While this drives prices higher initially, it ultimately leads to most money already being invested in the market, with nothing on the sidelines. If every market participant is fully invested, there is no money waiting on the sidelines any more to buy dips. This can exacerbate market selloffs. This is why seasoned investors get a bit cautious when there is a high level of bullishness in the market and the so-called “fear index” — the VIX — is low.
Another time-tested Wall Street axiom is that investors shouldn’t “fight the Fed.” What this means is that when the Federal Reserve Board is keeping rates low and taking other actions to increase the money supply and inflate asset prices, investors should ride the wave. However, these conditions are also ripe for creating market bubbles. With low-to-no-interest cash available for market participants, prices tend to rise to overinflated levels. At some point, the Fed has to take the punch bowl away by raising rates and taking other actions to combat rising inflation. This in turn oftentimes triggers market corrections or crashes. Some market pundits believe we’re nearing the end of the easy money period shortly, as inflation has been on the rise.
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How To Respond to Bubble Signatures
In almost any type of market, there’s at least one of these “bubble signatures,” so you can’t base your entire investment strategy around just a single indicator. However, if all of these traditional bubble signs are present, you might want to take more of a defensive stance with your portfolio — particularly if you notice that you yourself are getting away from your own long-term investment strategy and becoming overly enamored with speculative positions.
No one can time the market, and even if everyone can agree that it is overvalued, a crash may not happen for weeks, months or even years. But if you see all of these signs flashing red, you might consider consulting with your financial advisor about raising some more cash or switching to less speculative investments.
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