It’s a word that seems to be floating around a lot more often, these days. But just what is a stock market bubble? And how do you know you’re not investing in one, right now?
As an app that helps you become a better investor at the Singapore exchange, Spiking provides helpful information and insights. In this post, we’ll take a gander at some factors that might suggest the presence of a bubble. More importantly, we’ll also be taking a look at what you as an investor can do about bubbles, whether or not they pop.
How the market blows bubbles
First, let’s check out what a market bubble is. Investor Words calls it a stock market phenomenon which occurs when a stock spiking in its sector doesn’t have fundamentals that seem to justify the sudden, significant rise in its price. The stock spikes in response to exaggeratedly (some people say “exuberantly”) high expectations of resale value. You can download the Spiking app to keep track of spiking stocks at the SGX.
The bubble is said to pop when the self-same stock suddenly spikes downward, compounded by (or resulting in) panic-selling of its shares. Investopedia adds that deflation occurs when no more investors are willing to buy at the super high price. It also says that bubbles form because of changes in investor behaviour (such as the above-mentioned high expectations).
How do we know it’s a bubble?
Writing for Forbes, Rob Russell says that a bubble only becomes clear after the market has emerged from one (in other words, only after it has popped). While he is not alone in saying this, Mr. Russell does, however, offer observations as indicators that a bubble is on the rise. Here are his tell-tale signs along with those of Investopedia’s Douglas Rice:
Stocks appear to be more expensive (but not for the right reasons or have no fundamentals to explain the spiking prices).
Consumers seem to be spending more (also for no apparent good reason).
Upward share pricing trends seem to be mimicking those that preceded three other historical bubbles (the 1920s prior to the Great Depression, the Internet Bubble of the 1990s, and the US housing bubble in 2007).
There is a flurry of mergers and acquisitions (which Spiking has also discussed in a previous post).
Media coverage of certain stocks is especially heightened (including paperback books).
Certain stocks seem to be the “in” thing (and everyone you know, whether they are knowledgeable or not, is talking about them).
Referring to a study by finance professors from New York University and Harvard Business School, Mark Hulbert of Market Watch also presents other warning signs that a bubble is in the works:
Less IPO’s on the market and lower IPO returns
Speculative companies have higher valuation than established, dividend-paying companies
Lower share turnover
Lower shares of corporate cash from issuing equities
Interestingly, these warning signs are presented as indicators of investor sentiment, which relates to the investor behaviour mentioned in our definitions above.
Can you exit a bubble before it pops?
The SG Young Investor (whom Spiking mentions in a previous post) likens predicting the next direction of the market to fortune telling or predicting a person’s future — almost impossible. Mr. Russell also says it’s virtually impossible to tell when bubbles are about to pop or how bad the bust is going to be.
After asking several experts what they thought about predicting pops, Vox was likewise told it was a fool’s errand. Vox does say, however, that investors can prepare or protect themselves in the event of a bubble, and offers some advice on what they can do:
1. Focus on stock market returns in the long run, instead of worrying about spotting a bubble in time. Besides, stock markets do experience genuine periods of solid growth, sometimes. What might look like a bubble at the outset might actually be one of these growth periods.
2. Develop a lifelong saving habit as your best defence against market bubbles. Saving 10 to 20% of your income during your entire working life is crucial to your success as an investor. This saving habit has to be maintained no matter how the market is behaving. Your investments are likely to come out all right in the long run.
Living below your means during your working years is another way to cushion yourself against a popping bubble.
3. Don’t be an alarmist, nor a super optimist. Just because prices are plummeting doesn’t mean you should panic-sell. Inversely, just because prices are spiking, doesn’t mean you should get carried away. Be aware, however, that if stock prices are high today, they could be a little lower tomorrow.
This doesn’t mean that stocks are not a good investment, as bonds and money market funds also have lower returns than before. It means that we should try to save a little more, especially if we don’t expect the market to perform spectacularly any time soon.
How else can we beat bubbles?
A company’s fundamentals, and not fluctuations in its share prices, is what the SG Young Investor says should be the key point for investors to focus on. If a company’s share price does go down while the company’s value stays the same, it’s an opportunity to acquire more of its shares.
When a company’s share price doesn’t seem to reflect its fundamentals or true valuation,
Investopedia’s Mr. Rice says you have one of two options. You can avoid the stock and play it safe, which would enable you to avoid bubbles. Or, you can or take advantage of the situation by buying the stock at a high price, with the hope of being able to sell it higher later on. This, of course depends on your personal risk preferences.
In any case, as an investor, it pays to be prepared whether or not there is a bubble on the horizon. You’ll be glad enough of it if there was one and it popped.
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