Investing legends such as Carl Icahn, Jeremy Grantham, and other Wall Street money managers and experts have warned about speculative bubbles for years. They claim equities are overpriced and vulnerable to sharp sell-offs.
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 crash as the air comes out of the bubble.
Can an investor spot a stock market bubble?
Will there be a stock market crash in 2023?
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 experienced an explosive rally for the past decade, witnessing one of the strongest and longest bull markets in history, at least until late 2021 to early 2022.
Although the S&P Index and Nasdaq Composite fell 35% and 37% during the February-March 2020 pandemic-induced bear decline, they also quickly recouped their losses and set new all-time highs by year-end 2021. The NASDAQ Compositive and many stay-at-home plays ignited growth and technology-laden indexes to soar to record highs.
Does this scenario resemble the 1998 Long-term Capital bailout and the ensuing speculative rally, leading to the 2000-2002 tech/telecom dot.com bubble?
Many traders and investors made a lot of money in the stock market. However, many astute investors were skeptical of the speculative fervor of the rally and warned of a speculative bubble.
How does a bubble start?
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 no longer matters as speculators are willing to pay 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 are involved in the market, the greater the chance for a stock market bubble. Traders tend to gravitate to specific stocks and industries, generally high momentum, trendy, and high-end growth securities.
When the masses see stocks soaring, the fear of missing out (FOMO) leads to further buying. The more hype, the more attention the stock receives, attracting more buyers and speculators to join the run. 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 falling. 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%-20% decline in a relatively short timeframe. It all depends on how big the bubble is. 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 bubble bursting is one way for the stock market to reset stock prices back to their real price 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 claim the Buffet Indicator, or the US stock market divided by the US Gross Domestic Product (GDP) and other fundamental ratios to help identify stock market bubbles.
For many years, some money managers and economists have warned of the risk of a stock market bubble. They claim investors focused exclusively on the tech sector and the stay-at-home plays, ignoring valuations. They also believe the FED's easy monetary policies and historically low-interest rates have inflated financial assets and forced investors to take on higher-than-normal risks.
Another interesting point worth discussing. A rolling bear market may have started as early as late 2021. Some call this market scenario a rolling recession bear market. Various sectors enter recessions at different periods. We have witnessed dramatic sell-offs in memes, international stocks, value stocks, small-to-mid-caps, economically sensitive sectors, cryptocurrencies, and now Technology and growth stocks. Does this imply the selling is nearing an end, as most SPX sectors have suffered bear market declines?
Bubbles are deceptive and unpredictable. It is challenging to spot market irrationality. It is only in retrospect after the bubble burst that an investor realizes it was a bubble. The bursting of a stock market bubble is scary and unsettling. Like playing a game of musical chairs, investors will seek to sell at any price when the music stops (the rally ends). After witnessing a few bubbles over the past decades, astute investors have learned to be cautious and respectful of market bubbles.
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, can identify concentrated positions in stocks. It can also help gauge potential bubbles in individual stocks, leading to a broad stock market bubble.
Please review the charts below for further information.