Most people have heard of the dot-com bubble. At the time, the Internet was the best thing since sliced bread. It was going to change our lives, and investors knew it. Nearly every Internet-related stock on Wall Street saw dramatic growth in valuations coupled with a high level of volatility.
Then, the bubble popped.
Online company share prices dove quickly in what proved to be a painful stock market correction. Those who thought they would see incredible gains in their tech stock investments were left holding a bag filled with nothing more than useless paper. Soon, life was back to normal, and stocks representing online companies were back to valuations based on strong fundamentals rather than speculation.
Since the dot-com bubble, there’s been a housing bubble, a cryptocurrency bubble, a cannabis bubble, and (most recently) a COVID-19 bubble.
Bubbles happen in the market all the time. And making your share of coin as these bubbles inflate and even after they pop isn’t as hard as you think. Nonetheless, investing during bubbles is a risky endeavor and should only be undertaken by investors with a healthy risk tolerance.
What Is a Stock Market Bubble?
According to Investopedia, a stock market bubble is “an economic cycle characterized by the rapid escalation of asset prices followed by a contraction.” The topic goes far deeper than this minimalistic explanation, but that’s the basic idea.
Market bubbles relate to entire sectors. Looking at the historical examples of bubbles in financial markets, you will see full sectors named before the word “bubble.” Bubbles in the market tend to affect entire sectors as they emerge or experience a new phenomenon investors believe can lead to significantly higher prices.
All bubbles in financial markets follow a path that includes three key phases: the catalyst that starts the bubble, the inflation of the bubble, and its deflation.
1. The Start of a Stock Market Bubble
When investors believe most stocks in a given sector are priced too low, they race to buy the best stocks, index funds, mutual funds, and exchange-traded funds (ETFs) within that sector. That’s just smart investing.
In some cases, practicality goes out of the window. Instead of taking the time to analyze investment opportunities within a particular sector properly, emotional buying takes place. Greed sets in for most novice and even intermediate investors, leading to buying decisions made in seconds rather than over days, weeks, or months.
At the same time, diversification seems to go on the back burner as the potential for dramatic gains in a single sector catches investors’ eyes. They make these decisions blindly, even with powerful investment analysis tools at their fingertips. Investors start making moves that appear more like stock trading or all-out gambling than educated investing.
That’s when the bubble starts.
2. The Bubble Begins to Inflate
As a child, you likely held a brightly colored wand, dipped it in soapy water, and blew through a circle on the end of the wand to create soap bubbles. Your breath quickly pushing through a soapy circle was the force that led to the inflation of your soap bubbles.
That’s similar to how financial bubbles inflate.
For share prices to rise, investors have to purchase that stock faster than they sell it. High-volume purchasing tells us the general investing public believes the price of a given stock or multiple stocks within a sector will rise in the future.
That belief becomes a self-fulfilling prophecy as the values of stocks rise. Typically, practical analysis, whether fundamental or technical, occurs before buying, placing a figurative ceiling on this growth. In the stock market, this ceiling is known as “resistance.” It acts at the point at which investors can expect a downturn in growing asset prices.
During a bubble in the market, resistance is nonexistent. Prices simply continue to inflate, making the bubble larger and larger.
As greed sets in and practical analysis flies out the window, purchasing continues, and prices continue to inflate.
3. The Bubble Bursts
A kid’s soap bubble is going to hit the grass at some point, and that’s where it pops. And stock market bubbles pop just like any other bubble.
The catalyst is the general investing public’s realization that prices have inflated. That’s when practicality comes back into the mix. Investors begin to analyze each stock they own within the bubbling sector of the market.
Valuations in the market bubble are high at this point. Investors hone in on an opportunity to cash in. Those who realize prices are overinflated before the bubble bursts or at the beginning of the pop realize the most significant gains.
When the bubble does pop, it happens fast. At that point, values quickly fall to practical levels — or even lower as the sell-off commences.
If the bubble was large enough, the entire stock market can be pushed into a bear market when it bursts. In fact, when the dot-com bubble popped, it caused the market crash of 2001, where share prices tumbled regardless of sector or, in many cases, asset class.
Pro tip: Make sure your portfolio is properly diversified in case an investment suffers losses. If you’re only investing in stocks and ETFs, consider adding real estate. You don’t need to actually own the property. Instead, you can invest indirectly through a company like Fundrise. Another way to diversify is by purchasing shares of fine art through Masterworks or farmland through Acretrader.
How to Spot a Stock Market Bubble
To exploit bubbles for profit, you must be able to spot them. Finding them is simple. You just have to study historical bubbles and know where to look.
With the exception of the real estate bubble, each of these examples happened in emerging markets. They illustrate what you should look for to determine whether a stock market bubble is taking place.
The Dot-Com Bubble (1995-2001)
This bubble took place as widespread Internet use took hold. With a new tool for things like research, reaching customers worldwide, and communication, it seemed to many investors that any tech stock in the emerging space would see dramatic gains.
The Housing Bubble (2006-2012)
Before the real estate bubble, we saw historically low interest rates from the Federal Reserve, unethical lending practices, federal tax policies allowing exemptions from capital gains, and the failure of regulators to intervene.
These factors led to home prices growing far beyond practical value. Other forms of real property, including commercial buildings, storage units, and apartment buildings, saw similar price hikes.
Investors saw an opportunity, quickly snapping up anything having to do with property. Thus, the real estate bubble was born.
The Cryptocurrency Bubble (2017-2018)
The cryptocurrency bubble is also commonly called the Bitcoin bubble. During this time, the ideas of cryptocurrency and the blockchain that cryptocurrency runs on were just starting to hit mainstream media.
The ability to track purchases, stay anonymous, and take advantage of gains not generally seen in the currency space led to incredible excitement among investors, leading to the bubble.
The Cannabis Bubble (2018-2019)
The cannabis bubble took place just ahead of a vote to legalize cannabis for Canadian adults. Widespread medical use of cannabis and surveys suggesting consumers wanted to legalize cannabis led to a belief among investors the United States and other countries would follow in work to reform cannabis legislation.
Cannabis-friendly investors saw an opportunity for any company that wanted to enter this emerging space, leading to the cannabis bubble.
Following Joe Biden’s win over President Donald Trump in the presidential election of 2020, cannabis stocks are beginning to gain steam yet again under the assumption that a Biden presidency may lead to federal regulatory changes that benefit the sector. As a result, a stock market bubble may quickly form in the cannabis sector again
The COVID-19 Bubble (2020-Early 2021)
The COVID-19 bubble, or coronavirus bubble, took place as a worldwide pandemic led to health- and economy-related fears. The virus spread rapidly among the global population, causing a push to create vaccines, treatments, tests, and technology to help protect people.
As a result, investors sent stocks associated with COVID-19 to the top in hopes of cashing in. When vaccines started to hit the market, overinflated coronavirus stocks quickly fell to more realistic prices.
Identifying a Stock Market Bubble
When you believe a bubble is taking place, there are three questions to ask:
1. Is Something New Happening?
Bubbles happen across entire sectors because the sector is emerging or the sector is experiencing something it hasn’t previously experienced.
For example, the housing bubble occurred because something new was happening. Regulations, Federal Reserve interest rates, and horrible lending practices created buying opportunities for people who generally wouldn’t have qualified for a mortgage. Demand flew through the figurative roof, and the housing bubble was born.
2. Are Investors Speculating?
Bubbles in the stock market inflate due to investor speculation. The overwhelming majority of investors believe that share prices will climb, buy shares, and create a self-fulfilling prophecy.
Take a look at message boards like Stocktwits or Yahoo! Finance to see if there is a buzz. Some excellent tools for researching investor speculation include:
- Yahoo! Finance has a “Conversations” tab for each stock on the market. You can get a lot of information about how the investing community feels about a particular stock by reading through the comments.
- Twitter is a well-known social networking site. When you type a stock ticker in the search bar, you can find the conversation surrounding that stock. Just remember to use the cashtag, which is nothing more than a dollar sign before the ticker. To search Apple stock on Twitter, you can type “$AAPL” in the search bar.
- Stocktwits offers a heat map tool that gives great clues as to what is bubbling. As you can see in the image below, most of the market struggled in the early phases of the COVID-19 pandemic. Technology and health care stocks are mostly in the green. The large boxes for these sectors show that social volume is incredibly high, and the light green color shows stocks in the sector are moving upward quickly. That’s a great sign if you’re looking for a bubble. Just make sure you see a sustained trend in the heat map over at least two weeks.
3. Are Sector Prices Climbing Abnormally?
During any bubble in the market, prices soar before falling dramatically when the bubble bursts. Look at the average performance of the sector you think is bubbling and compare it to current performance.
If the sector performance is far better than usual, a bubble is likely taking place.
How to Make Profitable Investment Decisions During Market Bubbles
There are two different types of investments to look for in bubbling markets. The first is the short-term play, and the second is the type of stock you can hold onto for a long time to come, even after the bubble bursts.
Finding Short-Term Opportunities
When looking for short-term opportunities in a bubbling sector of the stock market, the first thing to look for is validity.
Shell companies often issue press releases about getting involved in whatever sector is bubbling to take advantage of investor interest and the volatility that comes with it.
More often than not, these companies have nothing of substance, and the U.S. Securities and Exchange Commission (SEC) has warned investors against investing in them time and again. So take the time to do your research before jumping into anything you find in a market bubble.
When looking for these opportunities, start by looking for specific stocks people are buzzing about in the bubbling sector.
The Stocktwits heat map is the perfect tool for doing so. Click on the sector and look for the biggest boxes. These tickers have the most message volume, letting you know that something’s going on.
Once you’ve found a potential investment target, it’s time to dig in. Start by looking at the company’s offerings in the bubbling market.
For example, let’s say you’re looking at technology stocks during the COVID-19 bubble and you find Company A and Company B, both of which are seeing strong social volume, trading volume, and price growth.
Many investors jump right in at this point, but that’s how you lose money. Instead, you do your research and find out that Company A used to be called Company Z but renamed itself after bankruptcy. Company A also says it has shifted focus to work on COVID-19 products, but you find that the company is just buying wholesale masks and trying to sell them for a profit.
On the other side of the coin, Company B has had the name “Company B” since its inception. The company has a strong history of producing proprietary face masks and surgical gowns, among other types of personal protective equipment.
Company B has also seen a sharp uptick in demand for its personal protective gear as the COVID-19 pandemic spread.
In this case, Company A has a strong chance of leading to losses. However, Company B can position an investor for substantial potential gains.
When looking at stocks in a bubbling sector, look for these three things:
- A History. In the example, Company B had a strong history of producing personal protective equipment. Company A had a history of bankruptcy and name changes. During bubbles, new companies and shell companies jump into the fray, hoping to get their hands on investment dollars they don’t deserve. Make sure you look for a strong history in the space to steer clear of these risky investments.
- An Increase in Demand. In the example, Company B was realizing a notable uptick in demand while company A tried to find new customers to get retail dollars for its wholesale products. An increase in demand means that an increase in revenue is on the horizon, making for an attractive investment opportunity.
- Proprietary Products. In the example, Company B had been producing proprietary personal protective equipment for years. Proprietary products are products no other company can make due to patents and other intellectual property. Companies with successful proprietary products in a bubbling sector tend to perform best in the stock market.
If the stocks you’re looking into have the three things mentioned above, they’re likely a sound investment opportunity in a bubbling market, at least for the short term.
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Finding Long-Term Opportunities
Long-term bubbling market opportunities are harder to come by and require much more research, but you can reap incredible benefits. You’re looking for companies that can survive the bubble.
For example, when the dot-com bubble popped, most companies in the space realized dramatic losses, leading to bankruptcy.
However, there were companies like Amazon.com, Cisco, and Qualcomm that fell dramatically but survived the bubble. After reaching the bottom once the bubble popped, all three tech stocks have seen impressive sustained growth.
If you had invested in these stocks during the bubble, sold as the bubble popped, and reinvested once their values reached the bottom, you’d have made a series of highly profitable investment decisions. Moreover, Amazon.com is trading with a far higher valuation today than any pre-bubble prices it experienced.
Finding the long-term opportunities in a bubbling market starts with looking at the short-term opportunities you found. As the bubble pops and the sector begins to fall, it’s a good idea to sell and wait. That’s when the research into long-term opportunities begins.
As you wait for values to fall to the bottom, look into the company’s financial history. The SEC requires publicly traded companies to report financial data to their investors at least once quarterly. It’s called the quarterly earnings report.
You can find quarterly earnings reports by searching for the companies you’re interested in on the SEC’s Edgar database. Look for the four quarterly earnings reports leading up to the time when the bubble began.
Starting with the oldest of the four reports, take the following notes for each quarter:
- Revenue. Revenue is the amount of money the company brought in over the three months covered by the report.
- Net Earnings. Net earnings is the amount of money the company had left after deducting expenses from revenue. Some companies also make this available in a per-share figure, which simply divides the total net earnings by the number of shares outstanding.
- Debt. Companies have debt, just like consumers. Take note of how much debt the company has each quarter.
- Accomplishments. Has the company launched any new products or services during the market bubble? Have there been changes to management, accolades provided by regulatory agencies, or any other notable activities?
Now, compare your findings. During the four quarters before the bubble, did revenue and earnings consistently tick upward? Was there any notable increase or decrease in debt during this period?
If revenue and earnings were headed up and debt was heading down, you’ve found a company worth paying closer attention to.
Also, think about how the company’s accomplishments will lead to opportunities in the future. If they developed new products, will they be relevant after the bubble pops?
Based on your research, make a note of all companies you believe will survive the bubble and thrive after the declines. These are likely strong investment opportunities. But don’t dive in just yet.
It’s essential you wait until stock prices reach the floor. When bubbles pop, sectors see dramatic losses for the most part. However, there are periods of a day or two when things seem like they’re working back up just before falling again.
Making money following a bubble is a long-term, slow-and-steady play. You’re not going to miss much in a week or two. So wait until prices of stocks sector-wide tick up for a period of between two weeks and a month before diving back in. That helps protect you from a sudden crash caused by a bubble that hasn’t completely deflated.
Pro tip: If you’re going to add stocks to your portfolio post-election, make sure you choose the best possible companies. Stock screeners can help you narrow down the choices to companies that meet your requirements. Learn more about our favorite stock screeners.
Making the right investment decisions during a market bubble can be very lucrative. However, it’s important to remember you’re risking a loss any time you invest.
While exploiting market bubbles for profit, keep in mind the following warnings:
Beware the Pump and Dump
Pump-and-dump schemes happen when publicly traded companies are looking to come up with cash quickly during hard times.
They pay promoters tens or even hundreds of thousands of dollars to pump their stock price up by building undue excitement in the investing community through marketing strategies. These companies then move to raise capital in dilutive transactions at high prices, leading to dramatic declines.
During dilutive transactions, companies issue more shares to sell without any real change in underlying value. That’s like cutting a pie into 10 more pieces because more people than you expected showed up to your party. Everyone ends up with a smaller portion.
You can avoid that by reading through financial reports to make sure the company can afford to survive for at least 12 months if it were to stop generating revenue today.
Remember That Bubbles Pop Quickly
When a soap bubble hits a blade of grass, it becomes a puddle in no time flat.
When market bubbles pop, we see much of the same. When the dot-com bubble popped, prices fell for several months, but investors felt the brunt of the losses in the first month.
As prices begin to fall, it’s time to start selling. Don’t wait until it’s too late.
Don’t Be Impractical
Over-the-counter (OTC) stocks are stocks not traded on a large exchange, like the Nasdaq or New York Stock Exchange.
Investors trade these stocks, which the government holds to much lower standards than those traded on more formal exchanges, on over-the-counter bulletin boards.
They tend to be smaller companies with shaky financial futures and have little to offer by way of revenue and assets. As such, it’s best to avoid OTC stocks unless you’re a seasoned investor.