It’s a Trap! How to Spot and Avoid Stock Market Bubbles
As an investor, there’s nothing more exciting than watching an asset you own climb higher and higher. There’s a sense of confidence in your decision-making and feeling of invulnerability when it defies expectations and breaks through to new highs on a near-daily basis. But, as with most things, if it seems too good to be true, it probably is.
While markets and assets can break out and hit new highs due to positive economic fundamentals or catalysts, investors should think critically when an asset grows beyond its reasonable limits. It’s not always easy to spot these false winners, especially when everyone around you is buying. But knowing what to look for could save you from making a big mistake in the long run.
Key signs of a bubble forming
There are certain characteristics of bubbles that investors can look for to avoid falling into the trap. Most investors are familiar with the tulip craze – the first known bubble that happened in the Dutch Republic back in the early 1600’s. Investors were buying tulip bulbs en masse, sending valuations sky high, despite the fact that there was no underlying fundamental support for the price people were paying for them.
One of the key characteristics of a potential bubble is its uncertainty. Investors might have a hard time figuring out exactly what the potential upside is or what the real intrinsic value of the asset actually is. There’s usually some degree of vague valuations and seemingly arbitrary estimates. Analysts might cite supply and demand forces for example, but can’t pinpoint exactly what the forces translate to in monetary terms.
Another big danger that generally goes hand in hand with bubbles is the use of leverage. When investors can put down just a fraction of what’s needed to control a much larger share ownership, the risks increase exponentially. Interestingly, margin levels in the stock market are often used as predictors of an upcoming market crash or bearish reversal.
Finally, investors can usually see a bubble forming when the majority keep buying an asset and ignore any and all warnings to the contrary. This irrational behavior is seen is every bubble, as investors feel like an asset will never drop because it’s so popular and/or keeps going higher. But when everyone is buying, smart investors know it’s time to sell.
It may be tempting to try to time a bubble as an investor – buy knowing its overvalued, but selling before the bubble collapses – but it’s best to simply stay away. You could get lucky and make a quick profit, but there’s a high chance you could get burned instead and lose more than you can afford to. The best advice for investors who spot a potential bubble is to steer clear and stick with assets that have clear fundamentals for going higher.