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What is a Stock Market Bubble?
When the term bubble is mentioned, a lot of people usually think about the spherical bubbles floating in soapy liquids. However, a bubble in the stock market has a completely different meaning. A bubble in the stock market is usually based on economic and market factors that can cause irrational movements in the price of assets. When the market tends to be overvalued and investors keep on pumping money into the market, a stock market bubble can be formed.
Basically, when market participants drive the price of assets above their actual valuation, a bubble or an overvalued market situation is created. However, we at Financial Education believe that understanding a stock market bubble is crucial to safeguard your investments. In this article, we shall explore what a stock market bubble is, how you can identify a bubble, and how to safeguard your investments. So, let’s get started!
What is a Bubble in the Stock Market?
In the stock market, trade, or economics, “bubble” is usually not the word anyone would want to hear. The term bubble generates fear among traders and investors as it can destroy wealth and even cause a market crash. A bubble can form in the stock market when investors push stock prices to the moon and assets become highly overvalued. This is a situation that can attract a lot of new investors as all they see are the high and attractive returns. However, when the bubble pops, the value of every investment goes down tremendously, resulting in huge wealth destruction and losses.
Generally, the term bubble is used in the stock market to refer to situations where there is an increase in the price of a certain commodity and prices exceed the actual valuation. This might be as a result of the increase in the demand for a particular commodity, stock, or asset over some time. When this demand gets to a particular price where it no longer seems rational, it begins to decrease based on its value in the market. This is usually referred to as the bubble bursts. Bubbles usually burst when interest rates skyrocket and asset prices reach their top.
Because bubbles are rare in the stock market, they generally follow a particular trend. These trends include an initial stage where prices start to rise slowly, attracting investors, and soon after the momentum sets in, the prices increase rapidly at a very high speed which eventually results in instability and a market crash. Then, a few manipulations begin to set in and there comes a stage usually known as the bubble burst.
Oftentimes, some investors use these trends to their advantage. A stock market bubble takes place when the prices of goods in the stock market are being manipulated far above their real value due to the systems of stock valuation. These bubbles could easily be predicted by stock market experts. These bubbles are usually seen as being rational and contagious. Bubbles occur in the stock market when a particular commodity becomes popular in the market. People become interested in knowing how it works and how they can earn profits from it. As a result, more people invest in it, and the asset eventually becomes overvalued, creating a scenario where the hype surrounding the asset becomes the cause for the rise in its price.
How to Identify if the Market is Overvalued and in a Bubble?
The stock market can either be overvalued or undervalued. When the demand for a particular asset increases rapidly, it creates a bubble and soon becomes overvalued. When investors invest in these assets; which are in high demand, they usually do so bearing in mind that they would be sold at a profitable price. When this happens, the market tends to become overvalued. However, in some cases, this no longer happens and expectations are not met. It could be a result of a change in the market trend. As a result of this, traders and investors sell off their investments below their expected/target price as fear of losses sets in. At this point, the market is said to be undervalued.
It is however not easy to identify if a market is in a bubble or simply overvalued. The ability to identify when a market is overvalued or in a bubble is necessary to place the investor at an advantage over others in the marketplace. Once this scenario can be identified, investors need to take action when necessary to avoid losses.
An overvalued stock market can be identified through the following means:
1. Calculating the General Market Ratio
Calculating the general market ratio is done the same way as when calculating individual stock ratios. It is easier to find the general market ratio because it is mostly calculated by market experts and the data is available easily. However, when the price-to-earnings ratio is calculated based on the data used in history, the average earned is usually known as the normal price-earnings ratio. Therefore, when the current data calculated is greater than that provided in history, the price-earnings ratio is known to be overvalued. An example of this was seen in the great depression of 2008.
2. Market Capitalization to GDP
Market capitalization is almost calculated at the same rate as the GDP ratio and is usually identified as a very powerful tool for identifying an overvalued market. The ratio of the general market can be identified easily as it does not change often in the market. The ratio is said to be undervalued when it falls beyond 0.7 and said to be overvalued when it rises above 1.25. Generally, investors tend to buy more when the market is undervalued.
So basically, the stock market can be termed as overvalued when market participants are willing to pump in money regardless of the prices and actual valuation of the assets. The only way investors can take advantage of this situation is by trading on short positions. This allows them to benefit when the prices of assets decline as short positions are inverse in nature.
Steps to Identify a Bubble in the Market
There are several ways investors and traders can identify bubbles in the stock market. It is important to identify these bubbles to know when to make an investment and when to exit them. The following steps can help you identify a bubble in the market:
- When the prices of assets increase abnormally: When there is a drastic increase in price over a couple of months that should most likely occur within years, a bubble is most likely to form. As a result of this, when the bubble bursts, the loss and destruction of wealth happens rapidly and volatility goes through the roof.
- When there is an abundance of cheap credit: This happens in bubbles that show up at late stages. This however increases the occurrence of risks as more people tend to borrow to invest, increasing their overall debt.
Most people believe that it is not easy to identify a bubble until it bursts. This could be true because not all activities that cause an increase in the demand for an asset would lead to a fall in the price of such assets. When you can identify a bubble at an early stage, you may be able to know if it would lead to a fall in the price of assets.
Stages of a Bubble
Identifying the different stages of a bubble are important as they allow you to adjust and rebalance your investments accordingly. These stages can easily be identified with a bit of careful analysis and research.
The early stage is easy to identify because it comes together with the rapid increase in the price of assets. This early-stage occurs within a short period, unlike the late stage that occurs over a prolonged period. Identifying a bubble in its initial stage is easier when compared to identifying a bubble in its final stage. The early stage of a bubble brings in new investments and investors and usually creates new market opportunities. This leads to more market expansions and even more employment opportunities.
The late stage of a bubble is a corrective stage that helps to clear out the excessive investments that saturate and slow down the market. These two stages unfold into several other stages identified as the various parts of a market bubble. These stages can be identified by similar characteristics though they are actually different.
1. The Stealth Stage
The stealth stage includes investments from investors who have identified the market risks and know that there is an opportunity in the future, but they do not necessarily act because these assumptions are made for the future. Those who invest at this stage often do so very quietly and carefully. Their reason for investing at this stage is a result of access to insider information or critical data that can cause massive movements in the market. As the prices increase at this stage, they often get unnoticed by the general public.
2. The Awareness Stage
This stage welcomes many more investors and people tend to put more money into the stock market. For some people, it lasts for a short period as they tend to cash out very early. The Media often tends to describe this stage as being beneficial to the economy as it basically translates into a source of wealth creation.
3. The Mania Stage
At this stage, the price begins to go up drastically. The news begins to portray this as a very good period to make new investments. More people begin to invest in the markets, thereby pushing the prices to even greater catastrophic levels. The more the price increases, the more people become interested in investing. However, those who understand this trend begin to withdraw their money and sell their assets. Meanwhile, greed continues to attract new investors who generally have no idea of how the stock market functions.
4. The Blow-off Stage
Here, traders and investors begin to notice a change in the trend movement. While some begin to notice what is going on, others remain in disbelief and try to encourage themselves that the change is only for a short period. At this point, the prices begin to drastically fall and the fear of loss grips every investor. People start looking for ways to sell off their assets but either they do so with a huge loss or they aren’t able to because of the scarcity of buyers. People begin to go bankrupt and the public realizes how they made a blunder with their investments. Such events usually cause severe market crashes and in some cases can also start a recession in the economy.
Types of Asset Bubbles
There are several different kinds of bubbles. However, bubbles are classified based on the kind of assets that witness an increase in their value over time. When an asset bubble bursts, it usually becomes weaker on an average recovery. There are, however, significant differences in the effect of these bubbles. An asset bubble could be owned by different people and different segments of society. It might either be in equity or housing. The equity bubble is mostly owned by the elites in society. Therefore, it is segmented. The housing bubble on the other hand is not segmented as it could be owned by anyone in the society.
Asset bubbles could be caused by:
- Demand-pull inflation
- High-interest rates
- Assets shortage
The different type of bubbles are:
- Market bubble
- Commodity bubble
- Stock Market bubble
- Credit bubble
- Economic bubble
How to Avoid Getting Trapped in a Bubble
Getting trapped in a bubble and losing all your hard-earned money is something you should avoid at all costs. However, it is not enough to only identify a bubble at an early or late stage. As an investor, you need to protect your investments from these bubbles to avoid wealth destruction and losses. To do this, you need to avoid irrational exuberance. Avoid buying assets only because it looks like you will be gaining huge profits from them.
This is because most often the price will tend to increase for a very long period which would make it difficult to identify a bubble that is about to burst. Diversification is a good method to avoid getting trapped in a bubble. Here, you occasionally balance or allocate all your assets. You could also do this by learning how the economy and stock market function, and look out for trends that do not have a strong backing or valid reason for the rapid increase in price.
Market bubbles are also referred to as asset or speculative bubbles. These bubbles can occur in all kinds of assets and are usually a result of excessive speculation and greed amongst market participants. This often leads to irrational exuberance which shows a collective excitement among investors and traders. However, you as an investor should avoid jumping in with the crowd and always analyze every investment and ensure you never take irrational decisions.
This will ensure you do not get trapped in a stock market bubble. Additionally, before making any investment decision, always check the current market conditions and other factors that might affect the value of an asset class, as investments in the financial market are subject to market risk. If you liked this article, make sure to visit Jeremy Lefebvre’s YouTube channel “Financial Education” for more such informative content! Happy investing!