Let’s face it – even if you are a seasoned investor, you probably look over your shoulder and wonder when the next market plunge will be and how you can be prepared.
If you have not invested through a tumultuous market, you may not yet know the sinking feeling of losing a large percentage of your net worth in a single day or week. However, if you invest long enough, you are virtually guaranteed to live through many market downturns and subsequent recoveries.
After all, the stock market is often quite volatile, and history shows us that corrections and bear markets are fairly cyclical in nature, occurring every few years.
One of the hardest parts of investing is identifying investment themes that will outperform the broader index (or S&P 500) over the long-term. As buy-and-hold investors, the general thesis is to buy market leaders in specific growth-oriented sectors – whether technology, healthcare, or a disruptor in other industries.
However, often these areas can become overrun with like-minded investors, speculators, or novice investors simply chasing the price of rising stocks in a trendy segment of the market.
So What is a Bubble in the Market?
In finance theory, the value of an individual company is determined based upon its future distributable cash flow that is discounted back to a certain price for the business today.
Essentially, if you knew to the exact dollar what the business would earn each year over its life, you would quantitatively know what the business is worth at any given point in time.
While the price of the stock should be an indicator of what the business is worth, often times, market forces and sentiment will cause volatility in the price of the stock even if the factors influencing the stock market do not actually affect the cash flows and overall fundamental value of the business. This difference can cause wide discrepancies in the intrinsic value of the business versus the market capitalization – which is determined by the stock price and number of shares trading.
How Do Bubbles Happen?
Bubbles form when the value of an individual stock, segment of the market, or market as a whole become overvalued relative to its “real value.”
While the market is reasonably efficient, often forces sway the market value of companies to become lopsided in either direction at times – either overvalued or undervalued.
Psychology and human behaviors (including irrational greed), coupled with high-frequency computer or algorithmic trading sometimes causes certain asset classes to become widely overvalued and deviate from the true, underlying value.
Just like people who may not be “true fans” like to jump onto the bandwagon of successful sports teams who rarely lose, bubbles form when the crowd of investors (often newbies) pile into and hype up a certain stock or asset class such as Bitcoin until the fad ultimately ends, and the value plummets back to a more realistic price.
So, how can you tell if your stocks or certain sectors are in a bubble that is about to burst and plummet back down to reality?
1. Look for Signs of FOMO
The “fear of missing out” is often the primary and psychological engine that drives market fads into the stratosphere until there are virtually no more buyers to continue the ascension.
Greed and a “get rich quickly” mentality are often two negative human behaviors that can contribute to investors bidding up stocks or assets to the point where there is nowhere left to go but down. Most well-informed, seasoned investors have a diversified portfolio of stocks, ETFs, mutual funds, and bonds that can generate returns from 6-12%, depending upon the allocation. Investors who are 100% invested in the S&P 500 generally anticipate returns of 10%.
Chasing Returns
While steady returns historically generated by a broad-based index fund have proven to build substantial wealth over the long-term, most novice investors chasing a market fad would scoff at the idea of making “only 10%” on their money. For Bitcoin aficionados, a 10% move could be in a single day during the height of the craze.
This mentality and needing to achieve vastly outsized returns is an obvious sign of a bubble forming.
Non-Traditional Investors
While traditional investors are often partially to blame for participating in behaviors that could result in a bubble forming, one of the biggest signs that a particular stock or asset class is showing “bubblish” tendencies is when non-traditional investors suddenly become experts and begin pushing what could be seen as a new market fad.
As a fairly recent example, pot stocks and cryptocurrencies could certainly have real value and application – especially, within a well-diversified portfolio.
However, when inexperienced “investors” with no prior market experience suddenly come out of the woodwork advocating that these are the best places to put your money only on the thesis that they have doubled or tripled their money in a short period of time, this is a sure sign you could be looking at a stock in a bubble.
If there’s no other basis for an investment thesis other than historical returns, and this fact is driving the price up, chances are you could be looking at an overvalued asset class ripe for a pullback.
How Does FOMO on Huge Gains Cause Bubbles?
When no more demand exists for a particular stock or asset, the price will naturally fall until either buyers pick up the shares at discounted prices or panic ensues and an even more severe drop occurs.
Generally, if there is real value in the underlying business, the price will be too cheap to ignore on a pullback. Buyers will then swoop in to take advantage of the lower levels.
Conversely, if there is not a whole lot of value in the business and the price has been inflated by novice investors and trend-followers for no rationale reason, there will more than likely be a mad rush for the exits.
This fire-sale results in the bubble “bursting.”
2. An Investment Becomes Normal Conversation Material
Unfortunately, the vast majority of Americans have absolutely no interest in following the markets on a daily basis.
As a culture, one of the unspoken rules is to avoid “money-talk” and finances in conversation. Therefore, one of the biggest indicators that an asset class is overvalued occurs when everyone who does not have traditional investments or does not follow the market regularly suddenly becomes a market expert on a particular investment.
As an example, if the Uber driver you meet or the local bartender begins to tell you to buy a marijuana stock or particular cryptocurrency because of how much they have made in a very short period of time, chances are there is a bubble in that asset class and euphoria is the driver of the price increase – not fundamental value in the business.
Look for Obsessive Media Airplay
Another sign that the value of an asset class has gone up beyond its true worth is when news organizations begin running stories highlighting the rapid increase in value.
If CNBC begins to run specials highlighting the epic run up in the value of Bitcoin, there is a good chance this could be contributing to the craze. While you will obviously hear mostly financial news from CNBC and Bloomberg, an even bigger sign is when other non-financial specific news stations begin running stories on particular segments of the market.
Because news organizations rely on viewers and will only air what they think will bring in the biggest audience, they will often times pull stories from what is popular for the average person.
As previously mentioned, financial stories are typically not a hot topic for the average American. However, in both market bubbles and stock market crisis, most Americans suddenly become aware of the financial markets and news sources will cater to this sudden demand for financial news.
Another sign of sudden popularity is when Wall Street begins to produce new financial products centered around “cannabis plays” or “cryptocurrency ETFs.” A significant likelihood exists that there is just too much hype in these industries for you to be buying companies at a good price.
After all, the primary focus of these financial firms is to make money.
3. The Fundamentals No Longer Matter
As we’ve discussed, the value of any business can be determined based on the cash flow and earnings that it will produce for its remaining life.
Generally, companies that are in the growth stage of their lifecycle will receive a higher valuation from investors compared to more mature or declining businesses. This is because as the business grows, its earnings and cash flow also increase each and every year which justifies the higher valuation.
While it is perfectly reasonable for valuations for growth-oriented businesses to be higher than the average company in the market, sometimes, bubbles form in these industries that are new and growing or disruptive and taking market share in a particular segment of the market.
Too Much Credit Too Soon
Often times, the company in a particular growth or trendy industry will have extremely high revenue growth but deepening, unsustainable losses and no proof that they can become profitable.
While this is not a guaranteed sign that the business is doomed for bankruptcy as virtually every successful and now mature company has operated at a loss at some point in their history, losses cannot be sustained in the long-term. If investors do not require the company to grow responsibly and simply bid up the stock because of revenue growth and the industry is new and hot, the fundamentals may not reflect the true value of the business.
Eventually, investors may decide they have made enough money on the inflated stock price, sell their positions, and the value will drop like a brick.
Prices Inflate Beyond the Fundamental Value
When the price of the asset increases rapidly and goes well-beyond what the fundamentals and future earnings would justify, the stock or asset could be in bubble territory. Companies that are in new, emerging industries and are losing money are often the places that fad investors look to capitalize on big returns.
In order to capture the gains, they will have to jump off the sinking ship before everyone else heads for the lifeboats. Oherwise, they risk losing everything along with everyone else when the bubble bursts.
If the fundamental financial story of the company does not align with the market value, chances are that investors are too excited and the future prospects may be overexaggerated.