How to Spot a Bubble

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Have you ever noticed that equity investors can’t have nice things? As miserable as we are when stocks are going down, we’re even more unhappy when they’re going up.

There’s an empirical explanation for this psychological phenomenon. It’s called loss aversion. Humans are at the mercy of all sorts of cognitive biases, and one of the more perverse ones is that we experience far more pain from losing money than we experience pleasure from winning the exact same sum.

That’s why when markets are rising, stocks are said to be climbing a wall of worry. The higher stocks climb, the more investor anxiety mounts. That’s loss aversion at work.

Cut to today, with markets at record highs and valuations stretched by just about any metric you care to use, and it’s only natural for investors to question if stocks are in a bubble.

After all, stocks never go up in a straight line, but that’s pretty much what the S&P 500 did after bottoming out in late October 2023. The benchmark index gained more than 25% over the next four months. Such a torrid run has U.S. equities trading at some of their very priciest levels in history, according to BofA Securities.

“The S&P 500 is statistically expensive on 19 of the 20 metrics we track and is trading at its 95th percentile based on trailing P/E, based on data since 1900,” writes Savita Subramanian, head of U.S. equity strategy and U.S. quantitative strategy at BofA Global Research, in a note to clients.

Three signals for spotting a bubble

Happily, valuation is not a timing tool, as strategists take pains to point out. Subramanian actually argues that the market isn’t quite as richly valued as it appears at first blush. Perhaps most importantly, bubbles are as much of a psychological phenomenon as a financial one.

There’s no substitute for experience on Wall Street, which is why it’s always wise to listen to old hands when it comes to divining the market’s machinations. Nicholas Colas, co-founder with Jessica Rabe of DataTrek Research, started working full-time on Wall Street in 1986. He lived through the October 1987 stock market crash and has witnessed every boom and bust up close ever since.

Colas has developed a three-point checklist for “spotting unhealthy, runaway markets.” Here’s a thumbnail version:

The market for initial public offerings gets frothy. “After never averaging more than a 25% first-day pop, the IPOs of 1999 saw a mean day one gain of 71%,” Colas writes. “Moreover, there was an average of two IPOs/day that year (476 in total), a record back to at least 1980. Scarcity value doesn’t explain the first-day moves. Irrational exuberance does. U.S. equities peaked in March 2000.”

Colas notes that based on IPO activity, markets are still nowhere near bubble territory. There were just 54 IPOs in 2023, and they averaged a first-day gain of just 12%, he says.

Hallmark mergers and acquisitions (M&A) deals. “Exceptionally bad deals happen at the top, even if at the time they seem quite sensible,” Colas writes. “M&A activity is ultimately a function of CEO/board confidence. Just like retail investors chasing hot IPOs at a market peak, senior managers fall prey to the same overconfidence that the good times will last forever.”

Happily, M&A activity is only picking up now after a slow 2023, Colas says, “a good sign that equity markets are not yet in bubble territory.”

A double is a bubble. Colas has a simple rule of thumb to identify unsustainably high prices in a range of markets. Whenever the S&P 500 doubles in three years or less, stock prices decline shortly thereafter. The same is true about the Nasdaq Composite over any rolling one-year window going back to the early 1970s, notes Colas.

“A double is a sign of speculative excess because macro conditions are never so different that asset prices should rise 100% over a short period of time,” Colas says. “Markets are reasonably good discounting mechanisms. When prices double, you know speculation – not fundamentals – are driving those gains.”

Even the Nasdaq Composite, which is the frothiest equity market right now, is up “only” 40% over the past year.

The bottom line

None of these time-proven indicators points to a stock market bubble, but a bubble very much remains a possibility later this year, Colas says. Keep an eye on  the above indicators and you should have a heads up before it pops.

This article was originally published on this site