How to detect a market bubble

A bubble is defined as disproportionate rise in as-set prices. We witnessed it in early 1999-2000 and in 2007-2008, when the market rose to unsustainable high levels and then crashed. There is another less vicious term called “business cycle”, which comes close to being synonymous with “bubble”.

However, while a business cycle is a fairly common phenomenon and very much a regular feature of market-linked investments, a bubble, on the other hand, wipes out wealth and ends up harming the economy in a big way. In this article, we will discuss some of the ways to identify a bubble and ways to save ourselves from inordinate losses.

Equity or auction market Let us first understand how a stock market works. It is a large auction market where sellers and buyers quote the price of any asset (stocks, in this case). When the price matches, the transaction happens. Sometimes, the auction keeps on going and prices keep on rising. This creates a bubble in the market.

What forms a market bubble A market bubble is formed in the assumption that there are always buyers to buy at a higher price. Hence, people decide to pay any price for the stock in the hope that they can sell it at a higher price to someone else, thus earning a profit.

History is full of such events when large groups of investors made irrational choices and ended up losing not just their own capital, but bringing down markets around the world.

For example, let’s take real estate market in the period 2000-2008. The prices of real estate kept on rising, not because of inherent fundamentals, but due to the “quick riches” stories of people making 2-3 times the profit in short spans of time. People went on buying and selling real estate to take advantage of the market. The prices rose quickly. Then came a time when it became unaffordable to buy. Finally, all those who bought just before the bubble burst ended up with a property with reduced value without any buyer.

Similar things happen on the stock market. Markets keep going up because of general euphoria and hope of positive economic growth, and the typical rationale for an irrational market is that “this time it is different”.

How to identify bubble It is extremely difficult to point out the exact time or level when market has pe-aked. We can only use some criteria to identify the existence or pre-eminent occurrence of a stock market bubble.

Financial indicators For the stock market, the Price to Earnings per share (PE) ratio is the most well-known ratio to evaluate a stock. The PE ratio tells you how expensive the stock is. Very few people know that there is also a PE for the market. The market PE ratio can be used to identify if the overall market is peaking or forming a bubble. A market PE of 22 and more is a sign of an overheated market.

Economic indicators Economic indicators are what we see in the economy. In an overheated market, prices rise faster on rising demand. Interest rates are low. Noting the general trends in these indicators can give one a sense of where the market is or is likely to head in the near future.

Behavioural indicators Behavioural indicators are another way to identify a bubble. It is when everyone you meet advises you on stock market investment. When everyone claims to know someone who has made 50 per cent or 100 per cent returns in last three months, you can be sure that market is extremely bullish.

When investors take loans to invest in stock market, it is a sign of a bubble, as well as a sign of trouble ahead.

(The writer is the CEO of BankBazaar.com)