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What is a Stock Market Bubble? How to Know when You are in one

As of 8th September 2021, NIFTY has crossed 17000, which is an increase of more than 100% from the dip of 8000 when the COVID-19 pandemic started in March 2020. The global markets from almost all the major countries (USA, Korea, UK, etc.) have risen considerably in the last year. Many questions arise due to a sudden and tremendous increase in the financial markets in the world. Are we in a stock market bubble?

Figure 1: Graphs showing Indexes of major countries since March 2020

A bubble can be simply said as an exponential increase in the price of any stock or asset over a period of time. When the stock prices rise above specific parameters such as valuations, it can be said that there exists a stock market bubble. A stock market bubble is an economic and financial bubble formed when the price of an asset exceeds its fundamental value significantly. Now, it is the people themselves who create and burst bubbles. Behavioral finance is the key to understanding this phenomenon.

The current scenario is a perfect example of a stock market bubble as we have the markets driving up due to the lower interest rates, excess liquidity, and many new people starting to invest in stocks due to the pandemic. The people are enjoying the market’s bullishness while some financial pundits have started warning about the danger of a bubble.

It is essential to understand how to identify a stock market bubble to make investment decisions accordingly and hedge by investing in gold or bonds to protect themselves. It is not always going to be accurate, but there are several indicators and signs which might help on how to identify a stock market bubble. The most recent and famous example of a stock market bubble is the Dot-com bubble which exploded in the late 1990s. Other notable bubbles include the Great Depression of 1929 and the Japanese stock market bubble in the 1980s.

Now, how to identify a stock market bubble? Could anyone have predicted in 1999 that the Internet companies are a bubble and they would fall steeply someday?

There are no textbook methods or techniques to identify a stock market bubble. Every investor may have their own perceptions and understanding of financial markets. However, some indicators can help to check if the market is overvalued.

Prices are high relative to fundamental valuation | Peak Valuations: During a stock market bubble, the prices rise regardless of any news or valuation principles. They are just pushed up by the sentiment of the market and the herd mentality. Simply put, the fundamentals of a company are not increasing at the same pace as its stock price. Due to the pandemic, many businesses are still being affected, and the revenue is almost the same as pre-March 2020, but the stock price has been soaring exponentially. The stock price may be trading at 75X its EPS when pre-pandemic; it used to hover around 25X. The current NIFTY50 PE ratio is also 32.4, which is way above the average PE of 18-20.

High leverage Speculators may borrow money from the brokerages firm (on margin) or NBFCs to keep on the bull rally. The debt cycle keeps increasing, and when stocks drop, the investor wealth can be completely wiped out due to the high margin.

Government measures such as low-interest rates– Lowering the interest rates encourage people to borrow and invest. It also encourages foreign influx in the form of FDI or FPI. It is inversely related to the stock market. Lowering interest rates, the market goes higher.

Popularization of a trend | Behavioural Finance– The dot-com bubble had a story that “The Internet changes everything.” Similarly, when there is such a story, it gets popularized to such an extent that it lures the investors to get behind it. Even if the story promises something actually popular, the hype around it causes the prices to rise up exponentially, which leads to a bubble. Recently, meme stocks have been increasing exponentially, which gives a totally new direction to investing.

A lot of IPOs with oversubscription– During the dot-com bubble also, all the “Internet” companies launched an IPO to raise money. The time was such that people would invest in any “dot-com” company. Looking at the current scenario, the past two years saw many IPOs, out of which 90% were oversubscribed, which shows the market’s bullish sentiment. A prominent example of this was Zomato (which has been a loss-making company since its inception), opening at a premium of 56%.

Besides this, several more indicators such as the Buffet Indicator, SmallCap Index, and the Sensitivity Index help identify a stock market bubble. However, these indicators are not always accurate in predicting the bubble. One should look carefully at the scenario around and make decisions accordingly. In the present day, the market keeps on increasing due to the accommodative stance of the RBI and the excess liquidity. The question is: Is it a stock market bubble?

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