Five ways to spot a stock market bubble

Bitcoin, US tech, Tesla, GameStop and the housing market are in a potential bubble, experts say

Representation of the Bitcoin symbol in golden colors growing distortioned inside a colorful bubble levitating in the stock market, the fluctuation of this cryptocurrency has become very popular and grew so much since the creation of Bitcoin, a new generation of difital currency.
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Bubbles seem to be blowing up everywhere these days, as record low interest rates and unprecedented stimulus drive asset prices to dizzying highs.

There is a growing roll call of potential bubbles, including Bitcoin, US tech, Tesla, GameStop, non-fungible tokens (NFTs) and, arguably, house prices.

There is nothing new in this. History is full of bubbles, so what can the past teach us about today’s uncertain market?

Bubbles tend to follow a broad pattern. Investors get excited by a new opportunity. Prices rise steadily, then skyrocket. The anticipated correction doesn’t come. Euphoria sets in, sucking in the few remaining sceptics. Then … pop!

Here are five scenarios that have typically happened in previous bubbles – and are happening today, too. How worried should we be?

Asset prices are accelerating

Paul Jackson, global head of asset allocation research at asset manager Invesco, has examined 15 historical bubbles, from the South Sea Bubble of 1720 to the 2013 Bitcoin bubble, and has found a template similar to all.

“They typically involve a doubling or tripling of prices over a two- to three-year period, with acceleration in the final months,” Mr Jackson says.

The descent is almost a mirror image. “Once the bubble bursts, things move quickly.”

By that measure, Bitcoin is beyond a bubble. In the three years to April 21, it rose almost eight-fold, from $8,000 to $61,965.

There was acceleration in the final phases, too. In the past six months, it jumped six-fold, from $12,000 in October.

Now it’s below $40,000 and, according to Mr Jackson’s formula, it could have much further to fall.

He says Bitcoin is a clear bubble. Possibly an endless one. “It seems to be in a series of inflating and deflating bubbles.”

The US S&P 500 has also been going gangbusters. Three years ago, on May 18, 2018, it traded at 2,712. Today, it stands at 4,127, up 52 per cent. That’s fast, but it’s not Bitcoin fast.

It does look like a bubble by other measurements. The Shiller price-to-earnings ratio, which measures how expensive companies look by dividing their share price by earnings, currently stands at 36.61, more than double the S&P 500 mean average of 16.82.

History shows it has only been higher once before – at the height of the dotcom bubble in 2000, when it hit an all-time high of 44.19.

Worryingly, it was lower before the Black Tuesday Wall Street crash on October 29, 1929, trading around the 30 mark.

Bubble rating: Bitcoin is a bubble (now bursting). The S&P 500 probably isn't. Yet.

Governments have provided much fiscal support and household savings rates have risen sharply, boosting the pool of savings that can be invested in asset markets

Credit is cheap and abundant

Another common factor in late-stage bubbles is that credit is easy and cheap. This helps fuel higher risk behaviour, such as borrowing to invest.

We’re there today, with both “ample credit and liquidity”, Mr Jackson says. “Central banks have reduced interest rates to zero or even negative levels, and many have eliminated bank sector capital buffers.”

Governments have been at it, too, as they battle the Covid-19 pandemic. “They have provided much fiscal support and household savings rates have risen sharply, boosting the pool of savings that can be invested in asset markets,” Mr Jackson says.

By March, US stimulus totalled more than a quarter of gross domestic product, rising to around a third of GDP Germany and more than half in Japan.

US President Joe Biden has popped a $1,400 stimulus cheque into the bank account of any citizen earning less than $80,000.

This has boosted retailers such as online giant Amazon, but Fawad Razaqzada, market analyst at Think Markets, warns an over-stimulated market could drive up inflation and interest rates, and put a stop to cheap money.

“Investors are not getting too worried yet, but the possibility of high inflation expectations becoming baked in among the public will worry the Fed and stock markets.”

Bubble rating: If inflation is temporary, things will be okay. If not, cover your ears.

Early adopters fan the flames

Writer Gore Vidal famously said that “Every time a friend succeeds, something inside me dies”, and the same is true of investors.

They spend far too much time looking over their shoulders at how well other people are doing, in fear of missing out.

Now known as FOMO, the habit has been particularly marked among cryptocurrency investors. For many, this is the main reason to invest. They don’t want to kick themselves forever because they stood on the sidelines.

Mr Jackson says FOMO fuels every bubble. “Early adopters fan the flames by creating believable narratives that are then heavily marketed. Eventually, even sceptics capitulate, creating the final crescendo.”

The herd instinct is also at play, he says. “Nothing succeeds like success. Investors find it easier to buy something that has recently been going up.”

We only ever hear about the winners, because no-one ever boasts about their losses

Our natural survival mechanisms, honed over thousands of years, leave us prone to FOMO, Tim Bennett, head of education at investment company Killik & Co, says.

“Share trading has become the latest crowd craze. Over Webex and Zoom, in chat rooms and even in socially distanced public places, you will read about and hear tales of the spectacular gains being made, sometimes in a matter of hours, on individual stocks.”

The temptation is clear. “We only ever hear about the winners, because no-one ever boasts about their losses,” Mr Bennett says.

Bubble rating: Too many are gambling instead of investing. It can't end well.

There is a good story to tell

Investors aren’t completely fanciful. For bubble behaviour to take hold, there has to be a “kernel of truth” behind it, Mr Jackson says.

US technology stocks have a good story to sell, as companies such as Apple, Amazon, Microsoft and Google-owner Alphabet are making real money, not just in people’s imaginations.

“Although they still rely on investors buying into a dream of continued strong growth into the future,” he says.

The obvious danger is that investors get too excited and price in growth that never arrives.

Electric car maker Tesla is a good example. The cult of Elon Musk drove the share price up seven-fold last year, to peak at $880 in early January. At the time, its share price traded at more than 1,000 times earnings. The stock is down more than a third since then.

Even cryptocurrencies have that kernel of truth, as they tapped into the fear that monetary authorities were losing control of stimulus and the resulting inflation will destroy the value of fiat currencies and other asset classes.

Mr Bennett says the allure of making easy money is hard to resist. “Why wait 20 years to make steady gains when you can double your money in a morning? Our natural impatience and relatively short attention spans add fuel to the fire.”

Bubble rating: The stories have been getting taller. Maybe the crypto crash will remind us that things do not always end happily.

Assets go up in a straight line

Another sign of a bubble is where the prevalent view is dramatically one-sided for an extended period, as seen with US tech stocks and cryptos (until recently), Peter Garnry, head of equity strategy at Saxo Bank, says.

The problem is that long-term outperformance is sometimes justified, as seen with Amazon and cloud-based software company

“Both looked like bubble stocks 10 years ago, for different reasons, but their profitability has only increased over time, so the market priced these assets correctly,” Mr Garnry says.

Today’s stock market is not in a bubble, but there are pockets of over valuation, he adds.

“One of the early signs of a potential bubble is many-fold increase in the share price without obvious triggers such as revenue or earnings growth.”

One of the early signs of a potential bubble is many-fold increase in the share price without obvious triggers such as revenue or earnings growth

Mr Garnry cites zero-emission vehicle company Nikola as a recent example, which soared more than 650 per cent in just two months last year. “This was driven by high expectations for its technology, but subsequent events could not support the valuation.”

Mr Jackson shares his view that the stock market is not yet in bubble terrain. “Although, I think some sections are, notably the NYSE FANG Plus index, which tracks the top 10 global tech giants.”

Rupert Thompson, chief investment officer at Kingswood, is also confident. “Equity valuations are high but strong gains in earnings mean share prices still have some further upside.”

Something else common to every crash is that nobody can predict when it will happen. The worst thing investors can do is sell up, just in case. You can make a lot of money in the final leg of a long bull market.

Bubble rating: There is still money to be made, but this is not the time to be reckless.