4 Things About Stock Market Bubbles

During a stock market bubble, investors buy stocks at a high price in anticipation of a further rise. However, there comes a time when the bubble bursts and the stock prices go into a free-fall. Stock market bubbles generally happen in a particular sector / sectors.

It is always best to identify the bubble beforehand and guard yourself, even if it means moving against the market.

Here are some important things to know about stock market bubbles:

How are bubbles formed

Stock prices rise in case of high demand and fall when there are more sellers in the market. Demand is assumed to be directly related to the perceived profitability, prospects and value of the underlying company. However, some traders also buy and sell purely on market sentiment. This often leads to a sharp shoot-up in prices, much more than the fundamentals may warrant. This leads to a bubble, which often lasts for a long-time.

Bubble v/s bull-run

Analysts gauge a stock's value on the basis of the future profitability of the company. Forward PE or Price-to-Earnings ratio is one of the the key measures used to understand stock valuations using an estimate of the future earnings per share (EPS). The PE ratio helps you understand how much you are paying for each rupee the company earns. A high PE ratio thus signifies you are paying a higher amount per rupee earned by the company. While it is not easy, this can help distinguish between a bubble and a bull-run. If the PE of a stock is much higher than the average industry PE, there can be a case of a bubble. One should look at the PE ratio and compare the same with the future prospects of the company. There will be cases that the prospects are bright and hence, the PE is high. This is a case for a bull run in the stock. However, if things look out of sync, it may be best to wait for a short-term fall in the prices. If the PE ratio is continuously ballooning more than the company's fundamentals, it could be a bubble.

Management activity

The management knows the company best. So, their selling or buying of shares in the market could act as an important indicator of the company's future outlook. If you see the promoters selling shares in droves, then, in most cases, it may be time to quit the stock before the stock starts falling.

High correlation

Analysts try to understand trends in stock prices. They use a term called correlation. This measures whether stocks move in tandem. A positive correlation means that a rise in one stock almost always leads to a rise in another stock. In contrast, a negative correlation signifies that the two stocks move in opposite direction. Stock market bubbles are often preceded by a rise in correlation.One of the hallmarks of the bubble that blew up in 2008 and the crash that followed was the heightened tendency of stocks across the globe to rise and fall in tandem, according to a Livemint report, a business news portal.

Also Read:

Stock markets approaching bubble territory. Read more

How to survive a stock market bubble Read more