Investing legends such as Carl Icahn, Jeremy Grantham, and other Wall Street money managers and experts have been warning about speculative bubbles for a while. They claim that equities are overpriced and due for a steep selloff. The financial definition of a bubble originated centuries ago. It describes massive speculation that inflates market prices to an unsustainable level leading to a bubble burst. The rapid escalation of market prices greatly exceeds the intrinsic value resulting in a large crash as the air comes out of the bubble.
So, can you spot a stock market bubble? And will there be a stock market crash in 2021?
As mentioned before, a stock market bubble occurs when a stock or security costs much more than it is worth. It becomes excessively overvalued or over-owned. The stock market has been on fire this past year, witnessing one of the strongest and longest bull markets in history.
Although the S&P Index and Nasdaq Composite fell 35% and 37%, respectively on February-March 2020, they also quickly recouped their losses and set new all-time highs by year-end. The NASDAQ Compositive and many of the stay-at-home plays helped send the technology-laden indexes soaring to record highs.
Many traders and investors made a lot of money in the stock market. However, many remained skeptical or fearful of the rally as they missed the bulk of the rally.
What does a bubble mean in the stock market?
With stocks, a bubble is a psychological phenomenon. It begins when everyone wants to own the market, sector, or security in question. Since there is a limited number of shares available to buy, the more investors that want to own the stock, the higher the prices will go. As the rally persists, the stock price does not matter as speculators are willing to buy any price to own the position. Usually, a news story is a catalyst that excites the masses to join the buying frenzy. The more buyers involved in the market, the greater the chance for a stock market bubble. Traders and investors tend to gravitate toward specific stocks and industries, generally high momentum, and high growth securities.
When the masses see stocks going up, the fear of missing out (FOMO) leads to further buying. The more hype, the more attention it receives, attracting more buyers and eventually speculators to join. Speculative traders often do not wait for the stock to consolidate and reset. The fear of losing out outweighs the risk of the stock price losing value. The thrill of the chase, at first, now turns into an obsession to buy at any cost.
When the bubble finally burst, a sharp decline occurs. It may be a 10% drop or a 20-plus decline in a single day or week. It all depends on how large the bubble. For instance, the Tech/Telecom dot.com bubble burst led to the Nasdaq Composite Index plummeting 77% from peak to trough. Typically, the larger the bubble, the larger the decline. The bursting of the bubble is one way to reset stock prices back to their real value instead of their perceived value.
Fundamental investors often utilize fundamental indicators such as the historical P/E ratios or the Shiller P/E ratio to identify a bubble. Some have found the Buffet Indicator or the US stock market divided by the US Gross Domestic Product (GDP) and other fundamental ratios useful to help identify stock market bubbles.
According to some money managers and economists, the stock market is nearing a bubble. They claim investors are focusing exclusively on the tech sector and the stay-at-home plays. They also believe in the FED's easy monetary policies, and historically low interest rates have forced investors to take on higher than normal risks, which can lead to the start of a bubble. One interesting point worth noting. Recently, there has been a sustained rotation from the Tech sector toward recovery stocks, economically sensitive sectors, value investments, smaller-caps, and international stocks. The broadness of the rally implies that this is a sustainable US economic recovery hence buyers entering the marketplace rather than speculative type market behavior.
Bubbles are deceptive and unpredictable. It is difficult to spot market irrationality. It is only in retrospect after the bubble has burst that this was indeed a bubble. The bursting of a stock market bubble is scary and unsettling. Like playing a game of musical chairs, when the music stops, investors will seek to sell at any price. After witnessing a few bubbles over the past decades, astute investors have learned to be fearful of market bubbles. Although bubbles may be developing in a few stocks or sectors, it does not necessarily mean that a broad US stock market bubble is imminent.
Nonetheless, we find the bubbles graphs from Finviz.com depicting the market capitalization and stock price returns over the past year of various S&P 500 stocks plotted against their peers visually appealing, and most importantly, useful to help gauge potential bubbles in individual stocks as well as in the US stock market.
Please review the charts below for further information.