Stock Market Bubble: What It Is and How to Identify One

The stock market’s on fire this year. And we just experienced the longest bull market in history. But a lot of people are asking if we’re in a stock market bubble…

The coronavirus put a damper on the markets this spring, but they bounced back before the end of the year. The Dow fell 37% in less than a month and a half. In November, it made a new all-time high.

But the clear winner was the Nasdaq. Stay-at-home plays sent this index soaring sky-high. This made a lot of people very happy and some people very skeptical.

When there’s greed in the markets, there’s also fear.

You might be asking, are we in a stock market bubble? And if we are, when will the bubble burst?

These are fair questions. As a trader, you want to do your best to understand where a market might be going. That’s how you better learn to adapt.

In this post, we’ll look at stock market bubble indicators … What causes a stock market bubble, and what are the stock market bubble consequences?

We’ll help you see the signs so you can pick a strategy that works for you and learn to trade through any kind of market.

What Is a Stock Market Bubble?

A stock market bubble happens when a stock costs a lot more than it’s worth or the market in general is overvalued.

If you put your money in the market, you want to get back more than you put in.

In my trades, I aim to get back three times as much money as I can accept losing. That makes a trade feel worth the risk for me.

If you’re an investor, you plan to stay in the market longer than a day trader or a swing trader. Investors and swing traders are more vulnerable to stock market bubble bursts.

If you’re a day trader, odds are good you’ll be in cash when the market crashes — if you’re well prepared.

When you’re a beginner, it helps to have a team that keeps track of the market day after day … The SteadyTrade Team can show you the ropes. With hands-on twice-daily mentorship, you can hone your own trading strategy for any kind of market. Sign up today!

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What Does a Bubble Mean in the Stock Market?

Depending on your goals, financial market bubbles can help or hurt you.

Investors and analysts value stocks based on different measurements. Stock market bubble indicators can warn investors when a stock’s price is too high.

A popular indicator is the price-to-earnings ratio (P/E).

This indicator compares a stock’s current price to the earnings you might expect to get back from it. For example, if a stock trades at $10 and the company earns $1 per share, the P/E ratio is 10.

If nothing changes in the calculation, you might expect to make your money back in 10 years. That’s a long time.

In reality, people fear missing out on an exciting stock. This makes them buy it without thinking about the technicals or fundamentals. Buying on hype can create a stock market bubble.

But if you focus on a day trade, technical indicators can help. This is a good way to avoid the stock market bubble burst.

This TWIST podcast gets into the details of technical indicators.

What Causes a Stock Market Bubble?

When a stock gets too big for its britches, reality catches up. That’s a stock market bubble.

Think of it this way. Your favorite brand puts out a new clothing item or tech gadget. And it’s a limited edition. They place advertisements everywhere they can.

Everyone wants one now. But there are only so many to go around. In that scenario, you’ll have to camp outside the store to be one of the first to get the product.

With stocks, it’s the same thing. There’s a limited number of shares to go around. The only difference is that prices don’t stay the same.

The more people want a company’s stock, the higher the price will go, even if the product hasn’t changed. That’s what causes the stock market bubble on a small scale.

At some point, the stock’s ability to perform gets lost in the frenzy of people wanting to be first in line. Or not wanting to be last in line.

Cause 1: Hopium

What’s hopium? It’s the frenzy that occurs when buyers have hope that stocks and the market will keep going up. No matter how high they get, more buyers come in.

Usually, a catalyst excites them. For example, the government stimulus money doled out to combat the economic effects of the coronavirus crisis. When people have money in their pockets, they usually spend it.

Since the U.S. economy is 70% consumer-based, this gave confidence to both traders and investors alike.

Like I said before, the more buyers in a market, the bigger chance of a stock market bubble.

Cause 2: FOMO

When people see stocks going up, their fear of missing out (FOMO) kicks in.

They don’t want to wait for a stock to consolidate. They’re afraid it won’t come down for a long time and they’ll miss out. And sometimes they’re right.

Take Tesla Inc. (NASDAQ: TSLA). People tried to short Tesla for so long. Some people waited for a better price to get in, but it kept going up.

Then Tesla announced a stock split. This made buyers feel like they were getting a deal. In reality, depending on when you got in, the stock had months of gains in it already.

Join my daily Instagram Live sessions at 8:30 a.m. and noon Eastern — I talk about great companies like Tesla and the overall market all the time.

Cause 3: Hype

Penny stocks aren’t the only ones that get hyped. Sometimes a whole sector will trend.

The more buzz a new industry gets, the more attention and the more buyers.

People gravitate to the stories of certain stocks and industries. This brings in more than investors or traders. It brings in the newbie gamblers too.

They read something that sounds exciting and throw their money at it. It’s the thrill of the chase at first. Building real skills in trading takes time. It’s great to understand how hype can move stocks, but never blindly follow it.

Stock Market Bubble Consequences

When the stock market bubble bursts, it’s not pretty. The effects ripple out. It affects traders, investors, businesses, and consumers. Let’s take a look…

Consequence 1: A Sudden Crash

When the market crashes after a bubble, it’s usually a sharp descent. If you’re lucky, a 10% correction is enough to bring stocks back to earth.

It depends on how big the bubble gets. In the early 2000s, the dot-com bubble burst plunged the Nasdaq 76.81%.

The bigger the stock market bubble, the bigger the correction.

Consequence 2: Banks Stop Lending

The housing bubble in the mid-2000s wreaked havoc throughout the economy.

The subprime mortgage crisis caused mortgage-backed securities to collapse in value. Banks were stuck with worthless assets.

There wasn’t enough capital on their balance sheets to suffer the losses, so they reduced lending. This meant businesses couldn’t get the loans they needed to operate.

Banks now carry higher cash reserves. Let’s hope we’ve all learned from this crash so we can keep capital flowing in future crashes.

Consequence 3: Businesses Fail

Without an operating budget, a business can’t run. It can’t buy inventory or afford to pay staff.

At the same time, consumer sentiment drops. It’s bad news all around.

Small businesses get hit the hardest. Especially those starting out. Unlike bigger companies, they don’t have enough cash on hand to stay afloat on their own.

What Happens After a Stock Market Bubble?

A stock market bubble burst is like a big reset. Stock prices come closer to their real value instead of their perceived value.

If there’s enough fear in the markets, they might even end up priced at less than they’re worth. It can take a while for them to recover, though.

During a recession, investors prefer growth stocks over value stocks.

Stock Market Bubble Indicators: How to Identify a Crash

Indicator 1: The Shiller P/E Ratio

P/E ratios aren’t just for individual stocks. They can apply to the market as a whole.

The Shiller P/E Ratio looks at the overall market to determine when we’re in a stock market bubble.

Historically, the average P/E ratio is 16. If the market grows to multiples of this figure, it’s overvalued.

Indicator 2: The Buffett Indicator

Warren Buffett has his own stock market bubble rule. If the value of the U.S. stock market exceeds the U.S. gross domestic product (GDP), it’s too expensive for him.

Be careful with this one, though. It’s hard for the average trader to time the market. And research shows that getting out of the market too soon can cost you the same as leaving too late.

Are We in a Stock Market Bubble?

According to some economists, yes. The stock market bubble of 2020 focuses on the tech sector. Many of the 2020 stay-at-home plays were in the tech sector.

A surge of retail investors put their money into risky stocks, and it paid off. So far.

The Federal Reserve’s monetary policy also plays a part. When interest rates stay low, stocks stay up. And the stock market bubble grows.

Lately, we’ve seen steady rotation from the tech sector to recovery stocks. If company earnings can catch up to their valuations, things might be okay for a while.

It’s a delicate balance. StocksToTrade’s newest add-on feature, Breaking News Chat, helps you stay on top of the news that matters to traders. Two market pros alert members to news that can really move stocks. Get your 14-day trial for $17 here!

How to Trade in a Stock Market Bubble

Tip 1: Focus on Hot Sectors

No matter what direction the market goes, you can find at least one hot sector to trade. If the sector’s hot, the stocks can stay in play even when the broader market is not.

Tip 2: Know Your Time Horizon

If you’re investing in your 401(k), stay in the market no matter what. If you have 10, 20, or 30 years to wait out the downturn, you have more to gain by staying in the market than jumping out.

If you’re a swing trader and the uncertainty of a stock market bubble scares you, tighten your stop losses.

If you’re a day trader, you can have better luck. A true trader stays in cash most of the time so you’re potentially less exposed to market volatility.

Tip 3: Scalp Trade

If you know me, you know I’m a conservative trader. When markets get shaky, I often stay on the sidelines. But that’s not for everyone.

If you’re worried about uncertainty but still want to play the game, consider scalp trading or other strategies. You can paper trade on StocksToTrade to hone a new style of trading.

Is It Safe to Trade on a Stock Market Bubble?

This is like asking, “Is it safe to play musical chairs?”

When the music plays, you hunt for the best trades. When the music stops, you jet back into cash positions before everyone else does. Otherwise, you’re the bag holder with no chair. And that’s not a comfortable position.

As a day trader, you won’t have to worry too much about a stock market bubble. Your goal is to be in cash by the end of every trading day.

If you’re stuck in a swing trade and the market gaps down overnight, then you’re in trouble.

5 Ways to Survive a Stock Market Bubble Crash

Have a plan in place and stick to it. Don’t let emotions make the decisions for you.
Follow the “smart money.” It’s often ahead of the trend.
If you’re investing, it may be time to switch to safer assets.
If you’re a trader, make a watchlist every day. Sign up for StocksToTrade no-cost weekly watchlist here to find out what we watch every week.
Always trade with the market, not against it. If it’s a bull market, go long. If it’s a bear market, sell short.

Conclusion

A stock market bubble burst can be scary. If it’s your first one, you might panic. But take it from a dinosaur like me: You’ll get used to them over time.

The important thing is to keep your head in the game. Pay attention to the signs. Look at the different chart patterns.

Experiencing a stock market bubble provides an invaluable education.

Have your cash set aside and your plan in place. After seeing bubbles a few times, you’ll build up your intuition and learn to make the right moves like a pro.

Let us know what you think. Have you been through a stock market bubble? What moves did you make when it crashed? What did you learn about yourself in the process?