How Do You Know When a Stock Market Bubble is Coming?

Brett Chatz |

The only problem with bubbles is that they pop!

Signs that a Bubble is Being Formed

The status quo of the global economy is best described as precarious. We are undergoing significant uncertainty as to the future direction of commodity markets, equities, emerging market currencies, inflation rates and monetary policy. On the one side of the equation we have the US economy which is booming, and likely to experience its first interest-rate hike in several years. Across the Atlantic, the Eurozone has been injecting massive monetary stimulus into the economy via the ECB. Additional expansion will likely come to pass in early December as Mario Draghi of the European Central Bank (ECB) attempts to combat the persistently low inflation rate. China weakness has spurred tremendous financial uncertainty in multiple markets, including EM countries, and this has had a knock-on effect on the fortunes of multinational mining and energy companies operating in those regions. As a result, we are seeing indices on the London Stock Exchange such as the FTSE 100 falling victim to the weakness of companies like Glencore PLC. This trend is pervasive across the board. With Asia weakness, we are seeing global funds with Asian equity components limiting their exposure to China, Hong Kong and Japan. Trillions of dollars are exiting volatile regions such as Brazil, Russia, India, South Africa and China (BRICS) and a rebalancing of global capital is currently underway.

You may be wondering what all of this has to do with being able to spot an asset bubble?

Bubbles don't appear in isolation; there is a reason for their formation. The conditions need to be in place for over-inflations or over-valuations of stocks or sectors. One way to understand what a bubble is, is to understand what it isn't: a stock that is fundamentally sound, appreciating, has a strong return on equity (ROE), pays handsome dividends, and is valued at a fair market price is not experiencing a bubble. By contrast, a stock that rapidly expands in price without having performed adequately to substantiate that price valuation is possibly undergoing a bubble. Each and every component of the economy impacts on every other component. When a market is growing at a rate of knots, it begins to overheat. Nothing can be sustained forever, and eventually the cooling period will come into play. This takes the form of a market correction which is a 10% decline in the value of an index, or a massive correction such as was the case when the housing bubble burst in 2008.

How can we tell when a bubble is forming?

  • Too many mergers and acquisitions tend to cause a rapid increase in the price of stocks, particularly in the healthcare sector.
  • In any given year, if the number of IPOs (newly listed public companies) is substantially higher, there is simply too much cash being injected into the market.
  • When there are too many share buybacks by major companies like Facebook, Google and Apple, it tends to generate excessive activity for that company’s stock – especially if it's a blue-chip stock. What happens is company revenues decline appreciably, leading to a dangerous set of circumstances.
  • When stocks rise too quickly, traders and investors want to cash in by selling just as quickly. This leads to a crash in the stock. Panic selling begets panic selling, and so the seeds are sown.
  • Margin debt is a crucial component in determining whether an asset bubble is forming. If investors are spending more credit-financed money on stock purchases, you get a situation like what happened in China when the equities rout kicked in. $5 trillion was wiped off global bourses almost overnight.

Author Bio: Brett Chatz is a graduate of the University of South Africa, and holds a Bachelor of Commerce degree, with Economics and Strategic management as his major subjects. Nowadays Brett contributes from his vast expertise for the globally renowned spread betting company –InterTrader.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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