How to Identify Stock Market Bubble

August 22, 2014 Smart Trading Tips 3 min read
Stock market bubble- Friend or Enemy?

Market bubble is a phenomenon, where the stocks are inflated way beyond their intrinsic value in response to exaggerated high expectation of resale value. The bubble is said to burst, when the stock prices suddenly collapse or go into decline, creating panic among the investors leading to a large amount of selling.

Stock Market Bubble Friend or enemy

In simpler terms, the bubble is another way of telling investors that despite short-term fluctuations higher or lower, the markets will eventually determine the proper value of a security sooner or later.

For instance, if a stock’s proper value is Rs.10, but it is being increased to Rs.50  because of industry rally or speculations, then you can be rest assured that the stock price will eventually come down to its proper value sooner or later. The same logic applies to the markets as a whole.

Also Read : Sentiment Analysis: Social Media’s impact on Stock Markets

How to Identify Stock Market Bubble?

The best way to identify a bubble stock is to look for overpriced assets with no real reason to rally. And following ways can help you to identify such stocks:

  • Media is all over it: Media seems to be a very essential tool to draw attention. When media has a hold of the story, they beat it to death. They suddenly put all efforts to pull a lot of investors in a single stock, resulting in an overbought condition. So, to avoid being trapped to such flattery investment and hot picks, you just need to shift focus.
  • Books, magazines and analysts preferencesSome time books, newspaper and analysts seem to be very much bullish on the stock or a particular sector at the same time. Therefore, you just need to be a little cautious as many times a stock is intentionally promoted for personal gains and benefits.
  • Herd Behavior: Many times people start following advises and find themselves trapped with overpriced stock. So, the stock that shows a lot of buy interest from past few weeks needs to be evaluated first, and not be followed immediately.
  • Look At Past Prices: If the chart of past prices has increased upward sharply, there is a good chance that, when it returns to more normal levels it will move sharply as well. Sometimes the stock is said to rise because of some sudden increase in supply and demand or because company is reflecting impressive fundamentals. However, if there is a rise without any reasons, be cautious.
  • Look for Put buying: For identifying bubble we just need to see if professionals are buying more puts than calls. That’s an indication that the tide may turn. Professional seems to buy puts if they expect the price to fall.

Example of a Bubble

The global recession in the year 2008 affected almost every sector badly. The following example is the chart of S&P BSE Realty, which clearly shows a market bubble in the end 2007, where the overpriced sector appreciated. After that, in the middle of the year 2008, the overpriced market crashed, in which the real state sector paid its price mostly.  S&P BSE Realty from 13650 levels in the year 2007 dropped around 80% to 1150.

Stock Market Bubble

Also Read : Sentiment Analysis: Social Media’s impact on Stock Markets

How investors can gain from Stock market Bubble?

Attract investors: The stock market bubble, in a way, encourages trading and investing. Many investors, who do not even know the fundamental very well, earn good amount of money by analyzing simple strategies.  They just figure out the stock, which is overvalued and undervalued, from any of their investor friend or internet and create buy & sell position accordingly.

Can gain while rally: A rising share can be tracked easily than any other share. It has been seen that investors create a very short position and earn a good amount of money from the share that is appreciating without any rational fundamental reason. Day traders and swing traders mostly make gains from such share. However, investors must be cautious while deciding the time of exit.

Good position to short: Some savvy and professional investors gain immensely by identifying the stock prone to bubble burst or selling pressure as they know the ffundamentals of the stockundamentals of the stock, and follow the market regularly. Shorting the stock at top is a very good decision, which could get them a high gain.

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