8 mins read . 28 Jul 2023
We all fear stock market bubbles. Most investors tend to get sucked into the bubble when it is forming and they also enjoy a small part of the ride up. However, when the bubble implodes, the investors are a rather unhappy lot. The normal tendency is to blame the brokers, the analysts, the fund managers, and the regulators. But, the interesting part is that none of them creates a bubble. Bubbles are created when millions of small investors rush to buy stocks whose prices have no relation to reality.
Of course, the opportunity cost to sitting silently is that you have to enviously watch your neighbour making money in the markets. But there is a better way to do it. You can actually identify a stock market bubble in advance. All you need to do is to look for some tell-tale signs that a bubble is forming in the market. Once you identify the bubble, you know what and when to stay away from.
If you look back at the history of market bubbles, there is no shortage of bubbles in the market. There was the Tulip Mania in the 17th century when everyone started paying exorbitant price for tulip bulbs, not knowing its actual worth. It eventually burst. The South Sea bubble of the early 19ths century was the first real stock market bubble when people blindly subscribed to a company formed to take over British debt.
The most famous is the bubble of the Roaring Twenties between 1924 and 1928 spurred by a combination of Calvin Coolidge announcements on free trade and inflation control. It eventually ended in the crash of 1929 and a prolonged recession in the US. As late as the 1980s there was the Japanese real estate bubble when a small piece of land in Tokyo was valued at higher than the entire state of California.
Companies in Japan started to generate 50% of their profits from speculation and the result was the crash of 1989 and two lost decades for Japan. Subsequently, in recent times, we have had the Technology Bubble of 1999 and more recently the subprime bubble of 2007. All of them concluded with a lot of pain. The moral of the story; you can avoid being blown into a bubble if you can sequence the evolution of the bubble. Here is how.
Sequencing the evolution of a bubble may not be simple, but if you look at past patterns, it is not too difficult either. Financial historian Mark Higgins has a complete template to identify bubbles. Here is the sequence.
When you see any of these tell-tale signs, you know you are in a bubble. The challenge is to identify the stage of the bubble and be cautious accordingly. However, the million dollar question is what can investors do from a practical perspective?
Can you use the template to identify the next bubble and get out of the bubble in time. Here are some basic rules you can follow.
It is well known that those who do not learn from history are condemned to relive it. If you just read up the history of bubbles, you get to know what are the common features you need to look out for. Just avoid such stories!