It’s one of those terms that scares off potential new investors: bubble. The fear that if you invest right now, you could lose everything as stock markets are bound to crash any day. It’s a rational fear, especially now, but also one that might be preventing you from making profit.
So let’s take a look at market bubbles, and more importantly, figure out if we’re in one right now.
In simple terms, a market bubble is exactly what you’re picturing. A certain segment of a market, be it one company’s stock, or something as big as the entire U.S. housing market or even the entire stock market itself, gets bigger at unnatural speed. Picture a soap bubble being blown, growing first to the size of your fist, then your head, and then even bigger. Eventually, it’s going to pop.
When that happens to a stock or market, the price crashes, and many people who had bought in just before lose a lot of money, sometimes all of it. It’s important to remember that the rise is often caused by an outside factor. Often, it’s people speculating that a recent rise will continue. If they keep speculating, the price of the stock or market will eventually be divorced from fundamentals — that means the price of the stock will have no relation to the financial health of the company.
There’s a fun example to explain this: in 1637, the price of Tulips in the Dutch Republic skyrocketed. A bit before, the country had introduced a futures market for tulip bulbs. A futures contract gave you the right to buy a tulip bulb at a set price at some point in the future. If the price of tulips went up by then, you could get a great deal, or sell your contract for slightly below the market price to someone and make a great profit.
This started a speculative mania, and soon, people were buying and selling the contracts without ever holding a tulip in their hand. Some historical accounts claim that at the height of the craze a single bulb could buy 12 hectares of land. But in February of 1637, that all collapsed and the price of tulips cratered. People won and lost fortunes overnight.
The exact story of the tulip crisis is lost to time, but the story exhibits all the signs of a bubble: a rapid rise in price divorced from value, followed by a swift collapse. Some bubbles can be slower, but generally this is a good rule of thumb to keep in mind.
So let’s take a look at the state of the stock market right now. The S&P500 Index, a proxy for the health of the wider stock market, has had a terrific year in 2020, despite a global pandemic and record unemployment. As of Dec. 16, 2020, it was up almost 13% for the year.
Some have started sounding alarm bells over this: a fast rising market at a time when businesses are closing and the economy is arguably in one of the worst shapes it’s been in decades can’t be a good sign. Questions have risen over whether the price of stocks in general are divorcing from their fundamentals.
Unfortunately, there is no definitive answer to the question of whether markets are in a bubble right now. Bubbles are only definitively diagnosed after they’ve happened, and many attempts to predict them have fallen flat so far.
In the end, your risk appetite will dictate how and if you invest. If you invest, you always risk the chance of losing a large portion of that money. If you don’t, you also risk losing out on profit. The final decision is up to you.