The First Rule in a Stock Market Bubble – The Average Joe

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    The First Rule in a Stock Market Bubble

    victorlei

    July 16, 2020

    The first rule in a stock market bubble is, you don’t talk about the stock market bubble… Unless you want it to pop. Stock market bubbles form when stocks rise beyond their true value.

    • The Nasdaq, a performance index that includes some of the largest tech companies (e.g. Tesla, Amazon, Microsoft), reached an all-time high of 10,727 on July 13.
    • Analysts are concerned about a potential stock market bubble in the tech sector driven by high valuations, speculative investing, and irrational behavior.

    THE EXPLANATION

    Investors are comparing the current market to the dot-com stock bubble between 1995-2000. Many of the tech companies that fuelled the dot-com bubble were highly overvalued, unprofitable, and outright terrible businesses.

    The dot-com bubble popped in March 2000, sending hundreds of stocks down 80-90%. Two main factors led to the burst: the fed raised interest rates to control stock prices and Wall Street analysts began advising against tech stocks.

    • Everyday investors looking for quick gains were the most aggressive at the height of the bubble, investing over $260b in 2000 as the market was collapsing.

    Are we in a bubble today?

    Louis Gave, CEO of Gavekal Research, argues that there isn’t a bubble in the whole market but there may be one in big tech companies. Here are several similarities that can be seen between the dot-com bubble and today:

    • Record amounts of everyday investors in the stock market… These investors made up ~20% of the average stock market activity during COVID, double the volume from the previous year.
    • Unprofitable businesses and irrational behavior (i.e. retail investors pouring money into bankrupt businesses like Hertz and J.C. Penney)

    In the no-bubble side of the argument, tech stocks may not be as overvalued as they were in the dot-com bubble:

    • P/E multiple for the Nasdaq stands at 34.05x compared to a high of 72x during the height of the dot-com bubble (See our QOTW for explanation).
    • The Nasdaq index rose 147% in the past 5-years compared to 929% in the 5-years leading up to the crash dot-com crash.

    Stephen Suttmeier, chief equity strategist at Bank of America, believes a record $4.6t held in money funds could eventually be invested back into risky assets that could further fuel the stock market rally.

    THE ACTION

    We talked about several hedging techniques in recent issues including diversification and gold investments. That being said, another way to benefit from rising stock prices and prepare for a potential crash is to hold a portion of your portfolio in cash. In the chance of another market crash or pull back, one can buy up stocks at a discount.

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