Economic bubbles have always been a hazard for traders and though each has been different, there is always a steep run-up in prices followed by a sharp fall.
However, a fast rise in prices on its own isn’t necessarily a sign that a market is in a bubble, since such a move may be justified by market fundamentals. So how can you tell when one is forming?
There are twi main signs traders and market watchers look for, with examples from the dot-com bubble:
- A departure from conventional means of valuations
- An increasingly steep rise in prices
In the mid to the late 1990s, the market didn’t just wake up to the disruptive potential of the internet; it got completely swept up in it. Market participants started to believe that it wasn’t a company’s earnings that mattered, it was its potential. In other words, it didn’t matter that companies were hugely over-valued according to any conventional means because the conventional means of valuation no longer applied. The NASDAQ reached a price-earnings ratio of 107 at the height of the tech bubble, meaning it would have taken more than a century for the companies listed on it to earn back their valuations. Note that while a buy and hold investor who bought Amazon stock with this attitude would have done very well for themselves, most stocks went bust and even established players like Cisco lost 80% of their valuation.
It took more than 1000 days for the NASDAQ to rise from 1000 to 2000 points, but only 475 days to then hit 3000 points. After that, it took just 56 days to reach 4000 points and a further 71 to surpass 5000 points – rising far more quickly than the earnings of the companies listed on the exchange.