Learn How to Detect a Stock Market Bubble

Don’t be swayed, just look for the bubble

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.

Table of Contents

1. Don’t be swayed, just look for the bubble
2. What are the many bubbles of the past
3. How to sequence the evolution of a stock market bubble
4. Building blocks to avoiding the bubbles

What are the many bubbles of the past

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.

How to sequence the evolution of a stock market bubble

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.

1. In the first step to a bubble, you find a new innovation being hard sold by the promoters as an idea with long term mass implications. Bubbles are always formed around an interesting and innovative idea, which has mass market appeal.
    
2. Like in the case of many PE investors who got into digital start-ups in time, the early investors often make a windfall. This can be largely luck. The problem arises when they try to template this performance assuming it was investment acumen. A thin line, it is.
    
3. The early adopters never trigger the bubble, it is the late entrants who are driven by the FOMO (fear of missing out) factor. This is normally supported by an abundance of capital available at low cost. The idea is so appealing that it walks without profits too.
    
4. The problems start when the money supply tightens and that is a common feature at the end of most bubbles. Asset inflation stokes general headline inflation and the result is that the government and the central bank intervene to put the house in order. Interest rates are hiked and liquidity is tightened in a variety of ways.
    
5. Then comes the panic and the crash. We saw this recently in digital start-ups. When money tightened around early 2022, the VCs and PE funds stopped writing their cheques. Start-ups used to limitless cash to boost top line were suddenly confronted with the need to show progress on profits. The result was a panic and a crash.
    
6. Learning from history is time-bound. According to Galbraith, financial memory normally lasts for a maximum of 20 years or so. Not all bubbles are as serious as the 1929 bubble or the sub-prime bubble. The crux of the issue is that memory is short and people who lived through a crisis change over 20 years. This leads to new players and new enthusiasm in the markets, which periodically perpetuates bubbles.

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?

Building blocks to avoiding the bubbles

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.

• Bubbles are formed because for every fly by night promoter, there are thousands of fly by night investors. Just avoid the temptation to make your millions quickly. Even Warren Buffett created his wealth over 75 years.
   
• Avoiding bubbles means being lonely. It is hard to see your neighbour laughing all the way to the bank by just participating in the bubble. Still, if you can resist the temptation, you would be better off in the long run.
   
• Be happy of markets that are still sceptical. They are not close to bubble zone yet. Be careful of a market in which there are only optimists left. That is the most classic recipe for a bubble.

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!