How much more money would you have if you saw the tech bubble or the real estate bubble coming? If you had a crystal ball, playing market bubbles would be easy. Unfortunately, we can't know when bubbles will form or pop.
So instead of trying to catch the next big thing, what if you tried to avoid the next big thing? Doing so would probably be more profitable for many people. But that's easier said than done. All bubbles look great until they pop, or do they?
If a bubble is defined as when the price of an asset gets significantly above the value of the asset, then looking for overpriced assets would be the best way to spot the next bubble. Here are a few signs that something that looks really good is going to eventually look really bad.
- The Media Is All Over It
When the media has a hold of a story, they beat it to death. When oil prices skyrocketed, that's all you heard about. When real estate boomed, that was all the rage. They did reality shows about flipping houses. In the tech stock bubble was there anyone that wasn't watching their brokerage account and the ticker on TV every minute?
When stock tickers were installed in elevators it was a sign that it was a bubble. (Home price appreciation is not assured. Can you withstand the volatility in this market? Learn more in Why Housing Market Bubbles Pop.)
- Books Tout It As A "Can't-Fail" Way To Make Money
This ties into the media being enthralled with it. In the stock market bubble, books like "Dow 36,000" were all the rage. In real estate, seminars and books abounded with speakers like Donald Trump touting the glory that comes from buying real estate. The more books saying you can't lose, the more chances you will lose.
- Everyone's Getting In
When people that know nothing about the markets start to think they are experts, it's time to start looking for the door. When your friend, neighbor, co-worker or cab driver, in other words, someone that you know doesn't know anything about money or finance, is giving you tips on what to buy, consider that a sell sign.
Market trends don't last forever and typically the last one's in are the ones that are just following the crowd looking at the past returns and projecting them forward. At the top of the tech stock bubble, celebrities were touting their stock picking prowess. For the pros, this is when to run for the hills. (Is that crazy product going to be the next big thing? Learn how to evaluate these companies in Sorting Out Cult Stocks.)
A corollary to that is when people scoff at those that say it's a bubble. This is easily tested. If you ask someone if something is a bubble and they laugh at you, then it's very likely that it is a bubble. Why? Because the reason people buy things that are clearly overvalued is because they are oblivious to the risk that they are wrong. The confidence that exudes from those investing in a bubble is dramatic and anyone that poses a question about it usually gets laughed at.
- Look At Past Prices
If the chart of past prices has escalated upward sharply, there is good chance that when it returns to more normal levels it will move sharply as well. But prices can spike for good reason. For example, if an oil producing country goes into civil war and we can't get oil, prices will spike, but there's a fundamental reason for it. Demand is the same and supply is less. However, fast price moves upward without underlying fundamentals is speculation and a sign of a bubble.
This ties into the concept in finance called mean reversion that says that prices tend to move back toward the mean, or average, level. When they go high on speculation and well beyond the average, it's likely a reversion to the mean will occur at some point. Looking for that disconnection between price and value is the key to determining if it's a bubble or not.
- Look For Put Buying
To notice if the bubble has run its course, look to see if professionals are buying more puts than calls. That's an indication that the tide may turn. Pros protect their downsides by buying puts or, if they don't have a position, they just buy puts because they think the price will fall. Either way, lots of put buying isn't good for bubbly markets. (You can make money on a falling stock. Find out how going long on a put can lead to profits in Prices Plunging? Buy A Put!)
The value of an asset follows natural phenomenon such as supply and demand. Price follows the law of the jungle, kill or be killed, everyone for themselves. Prices can go drastically out of line, and stay there for long periods of time but then sometimes suddenly come crashing down to more reasonable levels or even lower.
The Bottom Line
When prices are out of line with value there are two strategies. Avoid it and stay safe or play it and buy high hoping to sell higher. The former would have avoided the recent bubbles, and future ones, the latter could make you some money or cost you a bunch. How much risk you take is up to you.