A bubble is a spike in price far above the fundamental or intrinsic value of an asset. Bubbles are usually identified conclusively only after prices return to fundamental intrinsic values. This is why an investor should look for market bubble signs long before a bubble is identified. We want to look for bubble signs so we can exit before the bubble deflates.
Market bubbles have been a part of investing for as long as investing has existed. By definition they draw masses of investors into the bubble or they wouldn’t exist. Many of them, at their own peril, never make good investments again after being burned in a bubble.
A stock market bubble usually begins with strong fundamentals that begin to drive the price higher. As the price moves higher and higher people get caught up in the “excitement” and don’t want to be left behind. When, seemingly, everyone else is making money it is human nature to ignore bubble signs.
Stock Market Bubble Example
The largest bubble I have seen in my lifetime is the technology stock market bubble that peaked in 2000. Can you remember the technology boom of the late 1990’s? It started with good fundamentals and glowing prospects for the future.
By 2000, investors believed in a “new paradigm”. The prices of technology stocks had risen to levels that earnings would have had to accelerate at unsustainable rates for decades into the future to justify their peak prices.
Thirteen years later, many of these companies are gone. Others, such as Microsoft (MSFT), Intel (INTC), and Cisco Systems (CSCO) have grown their earnings considerably, but still trade at a fraction of their highest trading prices.
Stock Market Bubble Signs
Here are 5 bubble signs to look for in identifying a stock market bubble:
1. Herd Mentality or Group Think
If the media is inundated with messages of success and the need to buy now, you should be skeptical. News broadcasts and commercials are two common places where “group think” and “herd mentality” are exhibited.
2. This Time is Different
An investment that does not match up to fundamental value research but requires an explanation as to why “this time is different” should be a red flag for the savvy investor.
3. The Barber/Coffee Shop Test
Listen to the culture. This seem quite simple but it works! When everyone in the barber or coffee shop is talking about an extraordinary investment, a wise investor should probably avoid or sell it.
4. Prices Skyrocket
When prices rise more than 50% in a short period of time it is a clear warning signal.
5. New Paradigm
This is exactly what happened in the technology stock market bubble. Investors came to believe that the benefits of a new way of doing things would last forever.
The benefits of something new won’t last forever. Competition has a way of evening things out in the long run. When investors believe in a “new paradigm” you should become more cautious.
After Noticing Bubble Signs
Once you notice bubble signs you have two choices. You can participate in the market bubble and play Russian roulette with your finances, or you can avoid the stock market bubble and invest in only fundamentally sound investments. Investors who believe they can outsmart everyone else and get out at the top of the bubble are not investing, but gambling.
Because I have chosen to be a value investor I have never participated in a stock market bubble. It really is a choice! You can choose to ignore the culture and your friends (who are bragging about how much money they are making). Instead make the choice to invest in value.
Choose to not participate in stock market bubbles by watching for bubble signs. You will thank yourself later.