At least two investing gurus -- Mark Cuban and Jeremy Grantham -- are worried that Wall Street now is in the midst of a stock market bubble. The key red flag for them is that share prices seem largely unaffected by meager second-quarter earnings reports or the pandemic that continues to rage on. Optimists argue that the market's strength is justifiable, as investors look forward to the end of the COVID-19 crisis and the recession it has caused. But bubble theorists like Cuban and Grantham don't think it's that simple.
Bubbles are fueled by investor sentiment, and they burst when that sentiment changes. If one has inflated in the markets today, it's time to reset your own outlook. You can do that with a clear-headed review of three takeaways from the 2000 dotcom crash and the 2008 housing market crash.
1. Hype can be good or bad
Bubbles tend to grow out of hype for a particular asset type. In 1999, the Nasdaq Composite index rose by nearly 86%. That followed four consecutive years of gains that ranged from 21% to 40%. Real estate price inflation in the mid-2000s wasn't quite as dramatic, but the gains were still there. Between 2002 and 2006, home prices rose by 10% to 14% annually. Near the end of both run-ups, demand reached a feverish pace. In May of 1999, an unproven and short-lived eToys.com raised $166 million from investors in its IPO. And in 2004, would-be homebuyers regularly had to offer well over list price to close a deal.
The trouble is, hype in itself isn't a bad thing. It could signal a bubble is brewing, but it also could be a sign of shared investor optimism and a generally bright outlook -- the signposts of a strong bull market. You won't really know which until after the hype runs its course.
For that reason, it's useful to be aware of hype and how it affects your buying decisions. Buy into the hype when you feel the asset has long-term potential. But be cautious if it feels like hype has you chasing easy, quick profits. And always stay diversified in case that trendy asset doesn't pan out.
2. Decision-making discipline drops off
In the late 1990s, investors scooped up shares of speculative internet companies without regard to their financial metrics, the quality of their business plans, or the experience levels of their management teams. Share prices soared, rewarding speculators and fueling even more demand.
The housing market implosion of 2008 followed a similar path, except real estate was the asset everyone wanted. In the years prior, lenders lowered their underwriting standards and pumped money into mortgages, driving price increases and demand.
In both scenarios, it was demand -- not value -- that drove rising prices. Demand is an integral factor in market movements, but at times it can be too influential on share prices. When that happens, investors will eventually recognize an overpriced stock and pull back. In normal times, those corrections can be severe, but temporary. In a bubble, the corrections are both severe and long-lasting.
Insulate yourself from unnecessary losses by staying disciplined with respect to your value-evaluation processes. Watch metrics, read earnings reports, and follow industry trends.
3. Effects are long-lasting
After peaking in 1999, the Nasdaq Composite index produced three consecutive years of losses, which ranged from 21% to 39%. At its 2002 low point, the index had pulled back to its 1995 levels. Housing prices hit their pre-crash peak in 2006, before trailing downward for several years. Prices eventually bottomed out in February 2012 in the vicinity of their 2003 levels.
When a bubble bursts, it wipes out years of wealth generation. Even if you didn't participate significantly in the price run-up, you'll still feel the effects in your portfolio, possibly for years. Ready yourself for that outcome by thinking through a stock market crash scenario. How would you respond if your savings suddenly lost 40% of their value? Would you have to rethink your retirement plans? Do you have enough resources on hand that you could wait seven or 10 years for your portfolio to recover?
There are two benefits to defining your crash response ahead of time. First and most obviously, now's the time to make any adjustments to your portfolio or cash levels. If you need to liquidate a few things to reduce risk, do it proactively so you're not forced to take big losses later. Second, having a plan in place reduces the chances you'll make short-sighted, emotional decisions should the market take another sharp downward turn.
Take a cautious approach
By this time next year, we'll probably know who was right in the great bubble debate of 2020. In the meantime, there's no harm in taking a cautious approach to market optimism, revisiting your evaluation methodology, and shoring up your finances. If the worst-case scenario plays out, you'll be ready to look ahead to the recovery that will eventually follow.
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