Crash Anatomy 101: 3 Ways To Spot A Bubble

By TradeSmith Editorial Staff

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Severe market crashes, the kind that send indexes down much more than 20%, come from one of two places: black swans and bubbles.

Black swans are unpredictable events that upend economies across the globe.

They’re rare, and you never see them coming. COVID-19 was a black swan event.

Bubbles, on the other hand, can flash warning signs prior to taking down markets.

Last week we talked about how to recognize a true crash. Today, we’ll look at bubbles.

Nearly every bubble is driven by irrational exuberance — when speculation goes overboard.

Too much money flows into one or more assets where the underlying value, whether it be future cash flows or tangible property, falls well short of the asset’s price.

Put more bluntly, the reality doesn’t match the hype.

Now, not every bubble pops, nor does every pop cause stocks to flop. But by identifying them ahead of time, we can create plans to reduce our risk.

To do that, we look at three key areas: stocks, sentiment, and valuations.

Stocks — Stories That Make No Sense

We have more retail investors, people like you and me, participating in markets than ever before, with more money and influence.

Right now, we’re investing in our own version of dot-com stocks.

Take Rivian (RIVN), an electric truck maker, which blew up to a $100 billion market cap, making it one of the top 200 largest companies in the world… and it hasn’t sold a thing!

How about a joke cryptocurrency that’s turned people into millionaires?

There are plenty of stories out there. The more frequent these become, the greater the signs of a bubble.

In fact, you can think of each of them as their own bubble. Individually, one could pop and not become a bigger problem. However, the more times it happens, the greater the odds it actually will become a problem.

Archegos Capital Management’s failure last spring provides an excellent example.

Bill Hwang, head of Archegos Capital Management, exploited a regulatory loophole that allowed him to amass immense amounts of leverage while keeping the banks he borrowed from in the dark.

Despite running this way for years, his fund blew up, creating massive losses for banks across the globe.

Some of the stocks he invested in, like Discovery Inc. (DISCA), saw shares plunge as banks unloaded Archegos’ positions to cover the losses.

Thankfully, the pain didn’t spread any further.

Yet we saw in the Great Recession how a bubble in one area could infect the rest of the market.

Housing prices that climbed beyond reason in several key markets led to a financial system meltdown that bankrupted Lehman Brothers and Bear Stearns while nearly destroying U.S. automakers.

It’s hard to say which bubbles will cause a crash. That’s why we do our best to identify all the possibilities.

Sentiment — The Warren Buffett Approach

The Oracle of Omaha said it best: “Be fearful when others are greedy and greedy when others are fearful.”

Market trends have a way of building emotional momentum, scooping up more and more people along the way.

It’s why one investor feels the urge to buy Bitcoin at all-time highs. It’s why another investor may dump all their shares after the Dow drops 2,000 points in a single day, hoping to save their future.

This momentum builds into a cathartic release known as capitulation. It’s at that point where there are no more buyers (market top) or sellers (market bottom).

The prevailing attitudes of a group of investors or the market as a whole are known as sentiment.

To identify a bubble, we want to find a point where sentiment has reached extremes.

Within TradeSmith Finance, there are a variety of tools to help me gauge market sentiment, from market health indicators to a Billionaires Club that tracks portfolio changes for some of the biggest and most well-known whale investors.

More data points mean a more informed decision.

Now, if you want a quick and simple way to measure investor sentiment, you can look for the following:

  1. Wall Street analysts continue to raise their price targets
  2. Financial networks rarely talk about problems in the market
  3. Everyone continually says to “buy the dip”
  4. Friends who never cared about stocks start asking you or telling you about investment ideas
I know these might seem silly. But these subjective measures work remarkably well to help an average investor gauge market sentiment.

And remember, this is just one part of the analysis.

Frothy Valuations

I love to barbecue. Every time I decide whether I want to fire up the grill, I perform an evaluation.

Sometimes I can’t wait to smoke some savory meats.

Other times, I’m just not in the mood.

The barbecue never changes, just my opinion or my valuation.

Investing works the same way.

Sometimes investors are willing to pay more for a stock. Other times, they want a better deal.

One of the easiest ways to value a stock is the price-to-earnings (P/E) ratio. You simply take the share price and divide it by the annual earnings over the last 12 months reported by the company.

Assume that you found a company that makes $1.50 per share every year. What price would you pay for the stock?

That depends on a lot of factors, from opportunity cost to how it compares to similar stocks. These considerations can and do change over time.

We can aggregate them to see whether a market is over- or undervalued compared to its history.

Take the S&P 500.

We’ve graphed the P/E ratio for the index below.

Right now, the S&P 500 runs a P/E of around 28.83x. The average P/E ratio from 1990 to the present is 24.30x.

So it’s a bit more expensive now, but not terribly so.

Are Stocks In A Bubble?

I wish I could tell you with absolute certainty, but I can’t. No one can.

What I can tell you are the facts laid out by this analysis:

  1. From meme trades to fly-by-night cryptocurrencies, there are plenty of bubble signs all over the market.
  2. People are extremely bullish. However, many investors expect a market crash. Bubbles that send stocks tumbling tend to happen when people aren’t prepared for them.
  3. Stock valuations are high but not astronomical. And with earnings set to grow in the coming quarters, if stocks trade sideways, the market P/E ratio will naturally decline.
But I want to know what you think. Do you see signs of a bubble? Are there some parts of the market that pose a greater risk than others? I’d love to hear from you. And while I can’t respond to every email, I do read them all.