Bubble Hunt – How can we spot market bubbles?
Market bubbles, economic crises, and market crashes cause havoc to everyone. Is there a definitive way we can spot these bubbles? No, not necessarily – they are notoriously difficult to identify and in hindsight it always seems obvious. According to a recent report by Greenwood et. al, they present four findings in the goal to indicate a market bubble is about to “pop”. It is important for investors to understand if a market is overinflated or overpriced.
The Red Flags to Watch For
There are a few things to watch when searching for a bubble. An obvious sign is a rapid run-up of prices. During a bubble there is potential for price spikes with a combination of desperation selling. It is imperative to watch for when prices break from an asset’s underlying value. To measure an asset’s value, take the market’s price and divide by 10 year average earnings after adjusting for inflation. According to Wall Street Journal, a Yale economist Robert Schiller found that the median price/earnings ratio of large U.S. stocks is around 16 – and suggested during an event of a bubble such as the one in the dot-com era is 44. The other method to indicate when a bubble occurs is during an exciting, innovative technology that is attractive to investors – so as a bubble develops, more investors will buy into the asset.
These are important red flags, but what really causes a crash? It involves volatility, speculation, rapid price increases, stock issuance, and an uneven rise in prices. A good example of this is when there is a lot of issuance of stock from a firm, many assets have accelerated price increases.
Historical Context
According seasoned investor, John Hussman, the bubble in 2000 and 2007 were noticed specifically in a small set of super expensive and over-valued areas such as technology, housing, and finance companies. He also speculated that low interest rates may imply a sluggish economy, which would translate to low revenues.
How Should Investors React?
Since there is a lot of uncertainty, investors should tread lightly. Therefore, it is important for investors to be very cautious when taking aggressive bets in the current bullish Trump market. Make sure to invest a small amount into risky assets and cut back on large company stocks. Best of luck and watch out for those red flags.