Before a bubble bursts, price volatility increases substantially as assets trade more based on momentum and less based on fundamental measures. This is when the bubble enters its โbiggest foolโ stage, in which buyers push prices to even more extreme levels because they believe a new buyer will pay an even higher price.
The party usually ends after central banks raise Interest rates . But the decline does not occur immediately. For example, the Federal Reserve began raising rates in June 1999, but the dot-com bubble did not peak (and burst) until early March 2000. Higher rates also burst the bubble in Japan. The first interest rate increase occurred in March 1989; In December of that year, the Nikkei 225 peaked and the bubble burst. And the Nifty Fifty bubble came to an end when the Federal Reserve aggressively raised rates between January 1973 and April 1974.
There are generally plenty of signs that the investment craze is overheating. Price-earnings ratios based on expected earnings rise to unsustainably high levels. The S&P 500's P/E, currently 22, is 29% above its long-term average. "That's worrying," he says. Sam Stovall chief investment strategist at CFRA Research, but it's nowhere near the benchmark's P/E of 27 in late 1999, just before the dot-com bubble peaked.
Declining earnings estimates are another โred flag,โ Stovall says. Be on the lookout for bleak business forecasts for future quarters. "If we can hear the optimism of company leaders about future growth and see that the numbers are better than expected," that would be a sign that the good times will continue, Stovall says. But when the conversation becomes less certain, it might be time to leave the match.
Did you hear a pop in the stock market?
When a bubble deflates, it is often unclear whether the market is experiencing a pullback (a drop of 5% to 9.9%), a correction (a drop of 10% to 19.9%), or the beginning from a fall. a bear market (a decrease of 20% or more), says Stovall. Some investors view initial dips as buying opportunities, only to see prices fall further.
The confusion persists until everything starts to drop in price and then it often seems like there is nowhere to hide. The stocks that had been successful are the ones that suffer the most, of course. Defensive areas of the market. They tend to hold up better. In calendar year 2000, for example, the year the dot-com bubble burst, the S&P 500 lost 9%, but the best-performing sectors included healthcare (up 37%), utilities (up 57%). more), finances (25% more). ) and the consumer staples (up to 17%). โWhen things get tough, the tough start eating, drinking and smoking. And when they overdo it, they go to the doctor,โ Stovall jokes.
Bonds also tend to do well. โMoney will flock to bondsโ or even bond-like stocks, such as utilities, after a bubble bursts, Trahan says. "That's usually the place to be." In 2000, as US stocks plunged, the Bloomberg US Aggregate Bond Index, a high-quality benchmark of US corporate and government debt, gained 11.6%. It would continue to generate an annualized return of 6.3% over the next decade.
Some burst bubbles have led to long periods of poor performance known as lost decades, during which stock markets stagnate and economic growth slows. After the stock market crash of 1929, for example, a drought in market returns lasted until 1939. Japan experienced several decades of slow economic growth and negative stock returns after the Nikkei 225 peaked in 1989; Only this year did the index regain its 1989 peak. And during the 10-year period after the dot-com bubble deflated, the S&P 500 lost 1% on average per year.
So where are we now? Is it time to cut and run? Or should we continue investing in this rally? Savita Subramanian , head of US equity strategy at BofA Global Research, remains optimistic. โThe S&P 500 has no signs of a bubble,โ he says. "In our view, this bull market has legs."
But Stovall, who is a long-term optimist, nevertheless sees โsmall bubblesโ that are beginning to worry him. The S&P 500 recovered all of its bear market losses on January 19, he notes. And since then, shares of companies of all sizes, styles and sectors have been in positive territory. "This rising tide has surely lifted almost all boats," Stovall says, adding, "we're in for a pushback."
The best defense against a stock market bubble
This is a good time to remember time-honored investment principles, such as diversification. Lisa Shalette investment director of Morgan Stanley Wealth Management suggests diversifying your portfolio now with exposure to US bonds and non-U.S. stocks.
Consider an Equally Weighted S&P 500 index fund , which holds all the stocks in the benchmark index in the same proportion, so it is not as overweight with the largest values. Or explore assets that zig-zag when stocks do, such as hedge funds or alternative assets.
Note: This article first appeared in Kiplinger's Personal Finance magazine, a trusted monthly source of advice and guidance. Sign up to help you make more money and keep more of the money you make. here .
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