Case Study: Are We Approaching a Market Bubble?

It has been quite an exciting month for the markets. Post-covid stocks are on fire after vaccines news came out one by one. Dow Jones hit 30,000 and Singapore’s Straits Times Index kissed 2900 points this week. We even have oil at US$45.

This is shaping up to be a solid year for the markets despite the pandemic and recession. Speculative stocks driven by Rohinhood investors have gone insane, causing poor fundamental value investors to question their own methods.

However, when I see greed in the markets, I will start to fear that we may be approaching a market bubble.

Is This An Equity Bubble?

Bubbles are best identified by credit excesses, not valuation excesses. Will we continue to see a market rally as we approach the last month of the year? Or will this be a bubble which will burst to reflect reality.

But first, let’s define the model of a bubble

1 – Displacement

The birth of a boom. This is generally the start of a potential market disruption which creates a myriad of profit opportunities. Some sectors will benefit, others will not. During the displacement, there will be a new confidence, but the growth is still slow.

2 – Credit Creation

The nurturing of a bubble. Every boom needs to feed to credit. Monetary expansion and credit creation (money printing) are largely endogenous to the system. Money can be created by the governments. Creation of new banks, new financial instruments and low interest rate environments also plays a part. These factors allow credit to grow more robust, enterprise to increase and profits to enlarge.

3 – Euphoria

Stonks only go up. Share prices are seen as only capable of rising. Traditional valuation standards are abandoned and new measures are introduced to justify price. Over-optimism and over-confidence rule. Phrases like “this time is different” and “new era” is often mentioned in conversations. We are approaching the market bubble.

4 – Critical Stage / Financial Distress

The bubble peaks and starts to deflate. We often see insiders cashing out. Fraud cases start to emerge and the excess leverage built up during the boom becomes a problem.

5 – Revulsion

The final stage of the process. Investor fear rises and are so scarred by the events in which they do not want to participate in the market at all. This usually leads to bargain basement asset prices in the market.

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So where are we now? It’s up to individual investors to identify which stage we are at now.

Here’s a brief checklist for your own reference.

• Sharp increases in the price of an asset such as real estate or dot-com shares
• Great public excitement about said increases
• An accompanying media frenzy
• Stories of people earning alot of money, causing envy among people who aren’t
• Growing interest in the asset class among the general public
• “New era” theories to justify unprecedented price increases
• A decline in lending standards

All Bubbles Break

History will repeat and repeat. All bubbles will eventually break and all investment frenzies pass away. Be wary when you see cheerleaders assuring you that this time it’s a new high or a permanently higher level of productivity or efficiency. The market is a voting machine in the short run but a weighing machine in the long run.

At this stage, it seems like we may be approaching a market bubble but I may be wrong and this rally may continue for much longer.

The market may wander far from fair price but eventually (and maybe after breaking your heart, your patience and your bank account), it will go back to fair value. All we need to do is to survive until that happens.

Cheers