Warning Signs of a Market Price Bubble

Market Price Bubble

A market price bubble is a spike of an asset value far above its real or intrinsic value. Bubbles are usually identified conclusively only after prices return to fundamental intrinsic values. Market price bubbles have been a part of investing for as long as investing has existed. By definition they draw masses of investors into the bubble or they wouldn’t exist. Generation after generation, multitudes of investors have experienced considerable financial harm due to participation in these various financial bubbles. Many of them, at their own peril, never make good investments again after being burned in a bubble.

Most market price bubbles begin with strong fundamentals that begin to drive the price higher. As the price moves higher people get caught up in the “excitement” and don’t want to be left behind. When seemingly everyone else is making money it is human nature to want to participate too.

Bubble Example

The largest bubble I have seen in my life time is the technology stock bubble that peaked in 2000. Can you remember the technology boom of the late 1990’s? It started with good fundamentals and glowing prospects for the future. By 2000, people believed in a “new paradigm”. The prices of technology stocks had risen to levels that earnings would have had to accelerate at unsustainable rates for decades into the future to justify their peak prices. Twelve years later, many of these companies are gone. Others, such as Microsoft (MSFT), Intel (INTC), and Cisco Systems (CSCO) have grown earnings considerably, but still trade at a fraction of their highest trading prices.

Market Price Bubble Warning Signs

Here are 5 warning signs to look for in identifying bubbles:

Group Think and Herd Mentality – If the media is inundated with messages of success and the need to buy now you should be skeptical. New broadcasts and commercials are two common places where “group think” and “herd mentality” are exhibited.

This Time is Different – An investment that does not match up to fundamental research but requires an explanation as to why “this time is different” should be a red flag for the savvy investor.

The Barber/Coffee Shop Test – Listen to the culture. This seems quite simple but it works! When everyone in the barber or coffee shop is talking about an investment a wise investor should probably avoid or sell it.

Prices Skyrocket – When prices rise more than 50% in a short period of time it is a clear warning signal.

New Paradigm – This is exactly what happened in the technology bubble. Investors came to believe the benefits of a new way of doing things would last forever. Competition has a way of evening things out in the long run. The benefits of something new won’t last forever. When people believe in a “new paradigm” you should become more cautious.

Once you have identified a potential market price bubble, you have two choices. You can participate in the bubble and play Russian roulette with your finances, or you can avoid the bubble and invest in fundamentally sound investments. Investors who believe they can outsmart everyone else and get out at the top of the bubble are not investing but gambling.

Because I have chosen to be a value investor I have never participated in a bubble. It really is a choice! You can choose to ignore the culture and your friends (who are bragging about how much money they are making), implement your risk management plan, and invest in fundamentally sound investments. Choose to not participate in a market price bubble and you will be thankful later in life!

Related  Reading: Risk Management

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