Stock market bubbles are primarily caused by speculation and disregard for the actual value of companies. It is characterized by an acceleration of stock prices at a rate that is disproportionate to the company’s gains in fundamental metrics.

It is an indication that buyers are over-enthusiastic about a stock to the extent of turning a blind eye to intrinsic value and paying much more for a share of the company. In the end, factors such as revenue capacity and growth potential end up counting for little.

How to spot a bubble

It is important to note that inasmuch as market bubbles are associated with speculation,  not every spike in prices can be linked to speculation. The interesting aspect about bubbles is that not only are they caused by speculation, but people generally tend to speculate as to whether markets are in a bubble or not.

In the end, we tend to acknowledge a bubble after they have burst. However, the basic guiding principle in assessing signs of a bubble is to compare stock prices against fundamental support metrics. The difficult aspect about bubbles is that they are not easy to spot at the initial stages because one can never really tell if the prevailing prices will hold or plummet.

How should you invest in a bubble market?

1. Diversify your portfolio

The idea behind diversification is to spread risks and increase the chances of profiting. One of the best ways to diversify is to go for ETFs of relatively stable assets. For example, gold is usually more stable than equity shares and typically has an inverse relationship with markets. Therefore, if you have part of your investment in equities and part in stable assets, you will have covered yourself against downsides in case of a burst.

2. Buy stocks with a strong dividend growth record

Companies that have historically maintained a consistent record of issuing dividends are a good cushion against bubble bursts. Identify large market cap corporations that have maintained a base dividend of 2.5% or more for the last fifteen years. Such stock will hardly be inconsistent with the underlying intrinsic value of the companies and will almost certainly remain resilient even during a bubble.

3. Tweak your portfolio

There are no assurances in markets. Even in a bubble, things can change rapidly within short spans. Knowing this, you should not wait for the burst but rather reallocate your stocks depending on how their prices relate to intrinsic value.

4. Create a blended portfolio

Also known as a “barbell” portfolio, this type of portfolio is one with a mixture of winners and losers from the previous financial year. The trick is to gain from the potential rise in previous losers’ stock prices and profit from the rising momentum of last year’s winners.

However, the application of this strategy is suitable at the beginning of the year. Typically, you should have ten stocks each from the winners and losers, to outperform the market returns.  Experience has shown that the barbell portfolio tends to outperform the market, even during bubbles as a result of the push-and-pull between winners and losers.

5. Cash in when time is on your side

Bubble markets are notoriously unpredictable. You should take in your profits when you’re still in a favorable position. If you are convinced that the price has moved to a level that is likely to push the market to the brink of a reversal, then you should be courageous enough to sell part of your stock.

If you are keen on keeping your money invested, you can use the money obtained from the sale of stock to buy safer assets such as treasury bills. Importantly, learn to listen to your guts and do not pay attention to distractors.

6. Take advantage of options

Options are an excellent way of staying safe in a bubble market. With these, you will have secured your right to either buy a stock or sell it at a specified date at a specified price. However, you will not be obliged to buy should the market go against your expectations. 

With put options, you will be able to cover your position against potential price pullback. In case there is a bubble burst, your put will gain value, thereby earning you a profit.

The downsides to market bubbles

  • Bubbles often trigger widespread market volatility. For example, marginal changes in bank interest rates can lead to disproportionately larger changes in the rate of payment of mortgages.
  • Bubbles influence poorly-informed decision-making in terms of allocation of resources. Such misallocation may have wider unintended consequences on the economy. 

For example, if the market pushes the prices of houses higher, then there is always a likelihood that developers will build more houses than the market demands. This can lead to widespread losses to the economy in the subsequent cycles.

  • Bubbles can lead to insolvency for firms whose stocks plummet during a burst. In the end, such firms default on their financial obligations to the other firms they are in business with. This can create a ripple effect that can trouble many more companies, thus adversely affecting the economy.

Bottom line

Bubbles can lead to significant destabilization of investors’ positions in the market. In addition, they can have far-reaching adverse effects on the economy. However, they also present great opportunities to profit from the assets held in securities markets. It is therefore important to employ the right strategy or a mix of strategies to help you get the best out of bubbles.