5 Signs Of A Stock Market Bubble

Investors should look for signs of a stock market bubble to protect their money. During a bubble, stock prices often sore to astounding heights. As a result, you may expect terrific growth from your portfolio.

Suddenly, the bubble bursts and everything comes tumbling down. Now, your amazing portfolio has lost a tremendous amount of value, jeopardizing your savings and retirement.

Look for these five signs of a stock market bubble. If you spot them, you may want to consider moving your money to safer investment options.

The Buffett Indicator Is Sky High

The Buffett Indicator is a ratio that compares the total market cap of all stocks to the GDP. The ratio gets its name from Warren Buffett, who once said that “it best measure of where valuations stand at a given moment.”

When the Buffett Indicator climbs extremely high, you have to wonder where all of the value is hiding. How can the stock market contain more value than the nation’s gross domestic product? It’s a confusing situation that reveals how unsteady bullish stock markets can become.

A look at the Buffett Indicator over the last couple of decades suggests that a high ratio spells trouble. Typically, the Buffett Indicator falls somewhere between 93% and 114%. As long as the ratio doesn’t stay at 114% for very long, the market can restabilize and avoid a bubble. When the ratio stays high for very long, you should start to worry.

Consider the dot-com bubble that happened around 2000. The Buffett Indicator skyrocketed to 139.5%. Apparently, investors believed that the market had nearly 40% more value than the GDP. They kept investing even though their actions made little sense.

When the bubble burst, the stock market tumbled to about 75% over the next couple of years. Some investors lost about 60% of the money they had in the market. Those who invested too heavily in technology lost even more.

The housing bubble of 2007 offers another example. When the housing market collapsed, the Buffett Indicator reached a 107.5% peak. During the crash, the ratio nearly fell to 50%. In other words, the market lost more than half of its value.

What does the Buffett Indicator look like today? Most recently, it was over 180%. No one paying attention to the market’s history can expect stock prices to keep growing without a serious correction.

Federal Reserve Stimulus Is Through the Roof

The Federal Reserve often steps in when it suspects that the economy needs support. A little assistance probably doesn’t mean much. The economy just needs a little boost to help the dollar retain its value.

What happens when the Federal Reserve dumps trillions of dollars into the economy, though?

It makes sense for the Federal Reserve to stimulate the economy during a recession. The extra money gives consumers and businesses the money they need to keep the economy going.

The COVID-19 pandemic, however, has created a stimulus package unlike anything experienced before. The stimulus package has already exceeded $2.3 trillion. Many politicians expect another round of checks and forgivable business loans before the pandemic’s threat ends.

Congress and the Federal Reserve had little choice when it stimulated the economy. Unfortunately, the stock market used the money to rally. Few economists believe that the stock market can maintain such a bullish position from money used to prevent a crisis.

The extraordinarily high Buffett Indicator probably has some connection to the stimulus packages. If the bubble bursts, there is no way to estimate how much money investors could lose.

Even a brief look at the S&P 500 compared to the Fed Balance Sheet shows that investors could be living in a bubble right now.

Crazy Stock Valuations

On May 1, 2002, Elon Musk tweeted that he thought his company’s stock price was too high. The stock’s value immediately dropped by about 10%. Still, it remained just under $800 per share.

Maybe $800 per share doesn’t sound outrageous. After all, Tesla has started earning millions in profits as it rolls out more vehicles and continues improving its battery technology.

Things rapidly changed over the next few months. While $800 may sound reasonable, the stock price topped $1,600 during July. A quick correction brought it down to about $1,400. Still, that’s at least $600 higher than the day Musk warned about the price.

What drives crazy stock valuations like the one pushing Tesla so far above its actual value?

Tesla isn’t the only example. If it were, you wouldn’t have anything to worry about. You could just avoid Tesla until the price became reasonable. There are plenty of companies with share prices that don’t hold up to scrutiny.

To some extent, the value of money, commodities, and shares depends on what people believe. Belief, however, can only support overwhelmingly high prices for a short amount of time.

Eventually, investors will start to worry that their overpriced stocks will fall rapidly. The fear will make them sell their shares. As more people sell, the value will fall faster and faster.

If this situation happens to companies across the stock market, investors could lose trillions.

CBOE Put Call Ratio Is Muted

Even the most brazen investors can start to worry when share prices get too high. When that happens, they often hedge their bets with buy puts. A put gives the owner the right to sell a certain number of shares in a company. The contract does not force the owner to sell. It simply gives them the option.

Investors usually buy put contracts when they think that the underlying stock’s value will fall below a certain price. By reserving the right to sell, they can limit the amount of damage that their portfolios suffer when a stock price plummets.

Imagine that you own five shares of Tesla at $1,400 each. You don’t want to lose the stock because it has such a high value. It could even increase! Then again, you know that the stock probably can’t maintain its stamina. It will fall at some point. When that happens, investors could easily lose $700 per share, a total of $3,500.

Instead of losing so much money, you could use a put contract to sell the stock when it reaches $1,300. That way, you can only lose $100 per share, a total of $500.

If you see a CBOE call is muted, it’s time to worry about a stock market bubble.

Stocks That Shouldn’t Go Up… Go Up

A stock’s value should increase when the company starts earning higher profits or releases a profit that investors believe will soon lead to higher profits. If a company doesn’t show evidence that it will start making money very soon, then its shares should not increase in value.

Despite sound reasoning, some shares do go up even when their companies don’t have viable ways of generating income.

CytoDyn, a pharmaceuticals company, offers an example of this situation. CytoDyn is working on cancer treatments, but it hasn’t made any money yet. Instead, it funds its research through investments.

Given the lack of revenues or products, CytoDyn should have a very low value. Despite this, share prices jumped from $3.20 in mid-June to nearly $9 by the end of the month. Nothing justified the price growing by over 250%, yet it happened.

Pharmaceutical companies often suffer from a lack of revenue because it takes a long time to develop and test treatments before the companies can start making money. Buying shares at extremely low prices could pay off eventually. When the stocks start to look unreasonably good, take a step back and think about why the change is happening.

Any industry can experience a bubble. The entire stock market doesn’t have to falter. Keep that in mind when you buy stocks that go up when they shouldn’t. They could fall soon.

Sign Of A Stock Market Bubble: Conclusion

As the stock market continues to perform better than the overall economy, more and more people worry that a bubble will burst. If that happens, many investors will lose a lot of money.

Unfortunately, bubbles often happen at the worst times. COVID-19 has the economy in dire straights. If the stock market plummeted, investors would likely find themselves with few opportunities left.

Their losses could make it harder for the economy to recover because fewer people will have money to invest in businesses. It’s not just scary for investors. A stock market bubble could affect everyone.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.