Stock Market Bubble Trading Guide

Sep 7, 2021 06:03 PM ET
Stock Market Bubble Trading Guide

A stock market bubble can be defined as a period of irrational exuberance or a time when companies’ valuations do not match with reality. It is a period where investors tend to believe that all stocks will always move in an upward trend. In this article, we will look at what a stock market bubble is and how you can trade in such a period.

What is a stock market bubble?

A bubble is a period of significant excitement about a financial asset in an extended period of time. The asset can be a commodity, currency, stock, and even a cryptocurrency. 

Bubbles have always been around. One of the best-known bubbles happened in the Netherlands in the mid-1600s. At the time, traders from India introduced tulip flowers and promoted them as the future. As a result, most people rushed to invest in the flower. Some took loans to buy the flowers. After a while, tulips found no buyers, and their prices dropped.

Another example of a bubble happened in the late 1970s when the Hull brothers decided to plough their inheritance into silver. They spent millions of their inheritance and borrowed more to invest in the metal, which they hoped would become equivalent to gold. Ultimately, the brothers filed for bankruptcy as the price crashed.

Similarly, a stock market bubble is a period where investors are fascinated by the stock market or a subsector and decide to invest in it. As the prices rally, many investors rush to take loans. As a result, company valuations become disconnected from reality. As the bubble bursts, many retail and institutional investors tend to lose a lot of money.

Examples of stock market bubbles

There have been many stock market bubbles in the past. The most famous is known as the dot com bubble that happened in the late 1990s and burst in the early 2000s. 

The bubble happened when investors became fascinated about the internet and how it would change the world. As a result, many of them started investing in all companies that promoted their .com suffix. Most of these firms were not profitable. The bubble burst in early 2000 when questions about tech valuations became popular among investors.

The next well-known stock market bubble was the housing bubble. After the dot com bubble, investors started investing in the property market because home prices were always rising. As a result, big banks like Bank of America and Lehman Brothers extended billions of subprime loans to millions of Americans. 

The situation changed in 2008 when defaults started rising, and property values started dropping. This trend led to significant volatility in the market and the eventual collapse of banks like Lehman Brothers and Merril Lynch. 

How a stock market bubble forms

While bubbles are not created equal, there is a similarity in how they form. In most cases, a bubble starts with a new trend in the stock market. In the two examples mentioned, the trends were the shift to technology and the housing market. 

As the sectors become more popular, investors start pouring money on all companies in the industry. This trend is then promoted in most financial media, and the investing crowd starts loving it. This, in turn, leads to significant valuations among similar stocks.

We have seen similar situations in the past. For example, we have seen companies in the electric-car industry achieve high valuations because of Tesla’s success. Some of these firms are QuantumScape, Nikola, and Xpeng. 

At its peak in 2020, QuantumScape was valued at more than $30 billion despite the fact that it did not have any revenue. Instead, the company was building a new battery technology, and its first product was expected to go on sale in 2026.

Further, we have seen elevated valuations in the cloud and Software-as-a-Service (SAAS) industries because of the success of companies like Amazon and Microsoft. 

In most cases, a stock market bubble burst is triggered by a single or a series of events. For example, the 2007 housing bubble happened as more banks announced higher delinquency rates. As a result, investors started to exit their banking investments. The situation worsened with the collapse of Lehman Brothers. 

Other causes of a stock market bubble burst are a suddenly hawkish Federal Reserve and problems in one of the companies involved in the bubble. 

How to trade during a market bubble

Many investors make a lot of money during a market bubble. For one, since stocks are constantly rising, their holdings are always making money. Still, to make money effectively during such periods, you need to know a few things.

First, you need to understand the phase the market is in. The easiest way to identify a bubble is to listen to what ordinary people are saying about the market. If they have an overall excitement, it is an early sign that a bubble situation is unfolding. You can also use the internet to find the themes that people are talking about. 

Second, you should focus on buying the dips to take advantage of an eventual rebound. Historically, stocks don’t move in a straight line. They usually go through phases where they decline and then rebound. You should use technical and price action analysis to identify key levels of entry. 

Third, always understand key concepts of trading like the Elliott Wave, the Dow theory, and accumulation and distribution. These are vital concepts because they tell you the phase of the bubble. For example, in the Elliot wave pattern, the third wave is usually the longest part of the bullish trend. It is then followed by the fourth wave, which is usually a corrective phase.

Finally, ensure that all your trades are protected. Fortunately, most brokers offer a tool known as a stop-loss that automatically stops a trade when a certain loss threshold is reached. Always use the tool to protect your trades when the stocks are rallying. 

Final thoughts

A stock market bubble is a relatively popular event in the financial market. It refers to a situation where a company’s fundamentals are significantly separated from reality. In this article, we have looked at examples of popular bubbles, how they form, and some of the key strategies you can use to day trade in these conditions.

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