How Do You Know If You’re In A Stock Market Bubble?

Investors live in constant fear of a stock market bubble. Major economic losses tend to happen when a bubble bursts, usually sending everyone looking for financial havens to park their money and wait out the worst of it.

Avoiding the worst of these crashes requires that you understand what causes a bubble, and how they burst.

What is a bubble?

A bubble happens when the price of something starts to rapidly rise and exceed its actual value. In the case of shares, this is usually when the price is far above the fundamentals (financial information) of the company. This behaviour usually cannot be sustained, after all, market forces always push prices towards a balance between how much people are willing to pay for its shares and how profitable it is.

Prices suddenly dropping and causing economic losses is generally referred to as a bubble bursting.

The earliest record of an economic bubble we have dates back to 1637, where Tulip Mania caused hyperinflation in the prices of Dutch tulips. The trade established many firsts in international trade – including the concept of futures contracts. Needless to say, this market eventually crashed and left thousands of people bankrupt.

A more recent example would have been the US housing bubble in 2006, which led to the subprime mortgage crisis that happened between 2007 and 2010. Here, banks and financial institutions started handing out housing loans to just about anyone who wanted one. This led to a rapid increase in property prices as demand soared.

In 2007, it was found that many borrowers couldn’t actually afford their new mortgage and defaulted on the loans. This drove down property prices as there was a sudden surge in the supply of property; as a result numerous mortgage-backed securities became worthless.

Can we predict it?

One would expect that our modern calculations and models would be able to predict bubbles before they happen, allowing regulators to introduce guidelines to correct the market before it bursts.

But that isn’t the case. It’s near impossible to tell if the price of an asset is within its intrinsic value. After all, who are economists to say that a house is being overpriced if there are still people willing to meet that price?

Due to this, all bubbles are only identified in hindsight – i.e. after they have already happened.

After all, not every drop in prices is classified as a burst. It could just be the market correcting itself and bringing prices down to a level that properly reflects the value of the asset.

That said, economist William Quinn points out that there are some common themes in all bubbles: 1) there is an abundance of money, 2) they occur in assets that have recently become easy to buy, and 3) they involve speculation about future price increases.

These themes do not guarantee that a bubble is forming, but it does give you some guidelines on what to look out for if you’re getting worried.

Is there a bubble on the Bursa?

On the local front, the trading volume on Bursa Malaysia has jumped 125% year on year. According to Bursa Malaysia, the number of new Central Depository System (CDS) accounts opened from January to July this year totalled 218,000, compared to 97,000 in 2019.

With the six-month moratorium on loan repayments ending this month, the million ringgit question is whether all the cash on Bursa will dry up suddenly.

While there is certainly the danger of investors suddenly withdrawing their funds to deal with loan payments, it does not appear that there is a bubble at the moment. Bursa itself points out that the telltale signs of a bubble are not present. The influx of new accounts does not correspond with an abundance of funds, while there has been little buying based on speculation in selected markets.

That said, there is no telling what will happen when the moratorium comes to an end.

What can you do about it?

You have two options if you are worried about a bubble bursting: get in and try to ride the bubble to the peak, or sit it out and go bargain hunting in the aftermath.

Riding the bubble and cashing out at the peak is not something we recommend unless you are well connected and have a lot of experience. It’s not for the faint of heart as bubbles could burst at any time. This is basically timing the market, and carries the greatest amount of risk for any investor.

Alternatively, you can park your investments and wait out the crash. Once all the losses are made, you can go shopping for undervalued stocks. You will still have to be careful when picking through the bargain bin, as some shares may not recover.

Whatever you do, it is important to avoid panic. Bubbles burst and stock markets crash all the time. These markets also recover all the time. So avoid doing anything hasty and do your homework before making changes to your investment strategy.