For investors who know they’re in a bubble, a series of warning signs can help with risk management when the decline comes.
An Investor may be able to avoid buying into an artificially inflated security or sector, and not get dragged down with a correction that turns into a free fall, if they know what to look for.
The following 10 signs can warn investors of a possible stock market bubble or a top:
- High Prices: High prices are often the most obvious sign of a bubble. Some bubbles inflate stock prices so dramatically that the irregularity should be obvious. During the technology run-up of 1999, for example, some investors saw stock price increases of $10, $20, even $70 every second, which led to staggering—but temporary—gains. It is abnormal for average people to make more money in a week in the market than they do at their jobs in a quarter.
- The market flirts with, but fails to match its highest peak: Since the market reached an all-time high of 18,262 In July 2015, it has approached 18,000 and then retreated at least 18 times. When the market tests or repeatedly tests, but fails to surpass its high point, investors should consider that they might be operating in a bubble or a top—and a market that is headed down.
- Record highs in leverage or borrowing: When individual or hedge fund borrowing reaches or surpasses previous peak levels—a trend that can be traced—a bubble could be forming.
- Stagnant earnings: Company earnings or profits, which can also be tracked, often plateau during bubbles. Investors should look for patterns. A hypothetical suspicious pattern would be the S&P 500 earning $100 one quarter, $101 the next quarter followed by $99 the quarter after that, followed by $98, etc.
- Decreased production: Lowered industrial production is a hallmark of an end to traditional bubbles.
- Shrinking Producer Price Index (PPI): Producers, who make and sell products, are often forced to lower their prices during bubbles because they are moving less inventory than other segments of the market.
- High-Yield Companies Defaulting on Loans: Businesses that pose a greater risk to lenders are forced to pay higher interest rates when they borrow. These are called high-yield companies. When these companies begin defaulting, it may be indicative of a larger problem in the overall economy.
- Declining Transports: A decline in the Dow Jones Transportation Index can also indicate a larger problem. If delivery services like FedEx and UPS are hauling fewer packages, it could just be due to increased competition, but it could also mean companies are selling fewer goods, which could lead to a recession.
- Follow the Fed: When interest rates rise, the market generally declines, which is why the Fed hikes interest rates as a means to pop bubbles. The more expensive money is, the fewer people are going to borrow it.
- The Beanie Baby crash example: In the 1990s, consumers engaged in a mad purchasing spree that led people to spend hundreds, even thousands of dollars on small, collectible plush toys called Beanie Babies, which retailed for $5. At one point, Beanie Babies accounted for 10 percent of all eBay sales. 60 percent of American homes had a Beanie Baby. Investors should be wary of any stock or sector that rises higher or faster than common sense can justify. Hyper-inflated prices lead to rapid declines — as the countless Americans who have attics full of worthless Beanie Babies can testify.
While investors would be wise to watch for all 10 of these signs, an even simpler monitoring mechanism exists.
The following formation occurs during corrections. The formation is the market and the 50 day moving average going below the 200 day moving average.
This formation has only happened 69 times in 116 years. This formation — and a little simple math — can help differentiate crashes from corrections. A market can’t go down 30 or 40 percent without first going down 10 and 20 percent.
A breakdown of different declines:
|Percent Decline||Industry Term||Historical Instances|
|o% to 10%||Normal Correction||12|
|-10% to -20%||Deep Correction||29|
|-20% to -30%||Deep Correction Possible Crash||15|
|-3o% to -40%||Crash||7|
|-40% to -50%||Potentially Devastating Crash||4|
Squire Asset Management research has found 5 different tactical methods of buying low and selling “high” that historically worked better than buy and hold. The disciplined exit methodology is in the above ranges of deep correction and deep correction and possible crash.
We do not recommend people do this without a trained and experienced professional, however we also know that around 50% of investors handle their own investments at Charles Schwab and other investment houses so anything is possible.
Knowing the difference between a crash and correction is that important.
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