How to spot a market bubble

The prices increase does not mean that there will be a collapse in the markets, but there are other indicators that give signals about it.

Price bubbles in markets and industries are notoriously hard to spot -- after the fact, they seem obvious, but ahead of time, not so much. Researchers examined dozens of crashes in specific industries to decipher what predictive measures, if any, could identify potential bubbles.

Dramatic increases in pricing don't mean much in terms of future returns, researchers found. Researchers instead identified a handful of other factors that might be more telling for those looking to figure out whether their investments will continue to go up or are headed south. It's not just price—it's speculation, volatility, stock issuance, accelerated price increases and a disproportionate rise in prices among newer firms.

Across 40 cases in the U.S. where stock prices of an industry have increased over 100% in a two-year period, researchers found a number of common characteristics among those that crashed.

Industries were dominated by younger firms, and there was significant volatility in individual stocks. There was also a lot of issuance—firms issuing new stock or going public—and price increases were accelerated, meaning they went up at an even faster rate than the six months before.

Greenwood pointed to the 1920s market crash and 1990s dot-com bubble as examples. In the '20s, the stock market overall was doing very well, but it was really dominated by a couple of industries, especially utilities. The '90s saw tech stocks soar. Both instances exhibited a number of the above-mentioned characteristics.

President Trump, before arriving at the Oval Office, often warned of an impending market crash, in a February 2016 warning the markets are in a "big, fat, juicy bubble." Since arriving at the White House he has changed his tune on the state of the stock market, instead touting it as a measure of his success even though it's well above where it was when he foresaw impending doom.

Greenwood declined to say definitively whether the broader U.S. markets are currently in bubble territory—his research has focused on specific industries, where specific characteristics are more easily identifiable.

"The current level of CAPE suggests a dim outlook for the American stock market over the next 10 years or so, but it does not tell us for sure nor does it say when to expect a decline," he wrote. "Investors should not let themselves be tempted to bet aggressively on the Trump bull market."

Source: TheStreet

Junior Trader Ivan Ivanov

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