A Brief History of Stock Market Bubbles & How Investors Prepare

Throughout hundreds of years of market history, stock market bubbles have occasionally been formed, grown, floated about, and then popped. They cover a colorful panoply—houses, dot-com stocks, railway shares, and tulip bulbs, to name a few. Each one is different from the others, but they all share a few very human common denominators: greed, exuberance, fear, excess speculation, etc.

After markets crawl out of the wreckage from the bursting of one bubble or another, the same questions seem to come up, such as: how did we not see that coming?

Stock market bubbles are marked by sharp price appreciation in asset prices over a period, sometimes spanning years, followed by an inevitable crash. Bubbles happen. What is a stock market bubble, how can long-term investors identify a potential bubble, and how can they protect themselves? Here are a few pointers.







 

 

What Is a Stock Market Bubble, and What Are Some Examples of Past Market Bubbles?

Definitions of stock market bubbles and what causes them vary among economists and market professionals. But defined broadly, a market bubble occurs when asset prices climb far beyond what’s justified by underlying fundamentals, such as those that determine whether a business actually generates profits or ever will. Growth expectations become exaggerated, and hype and emotions get overheated. What former Federal Reserve Chairman Alan Greenspan once famously called “irrational exuberance” can take over.

And there’s always a narrative—a general acceptance even—that “it’s different this time.” When the bubble pops, the public comes to realize it wasn’t really all that different.

Here are a few noteworthy examples (check out the infographic below for more).

Dutch Tulip Mania, the Netherlands, 1636–37

Soon after tulips were introduced in Europe from present-day Turkey, the plant became a status symbol in Dutch society. Speculators bought tulip bulbs to “flip” later at a profit, and prices surged to the equivalent of tens and hundreds of thousands of dollars in today’s money.













The Roaring ’20s and Crash of 1929

A few years after the end of World War I, the American economy underwent a boom, and the stock market soared amid commercialization of then-new technologies, such as the airplane, automobile, and radio. Borrowed money, aka margin, fueled stock market speculation. But the “Black Tuesday” stock market crash of October 1929 signaled the beginning of the end. Thousands of banks failed, unemployment jumped, and the Great Depression was under way.

The Dot-Com Bubble of the Mid- to Late 1990s

Remember the “new economy” where traditional business cycles and recessions no longer applied? Remember the quest for “clicks” and “eyeballs”? Well, it was fun while it lasted. A quarter-century ago, back when the Internet was still nascent territory, dot-coms were going public seemingly every week and tech shares soared, even though many of these companies were burning through piles of money and would never turn a profit. In March 2000, the Nasdaq (COMP) peaked above 5,000, then plunged, losing nearly 80% by late 2002.

What Are the Stages of a Stock Market Bubble?

There are typically five stages to a bubble: displacement, boom, euphoria, profit-taking, and panic. In displacement, a new product or technology gains the attention of more and more investors, or there’s a period of historically low interest rates that drives investors toward assets with potential for greater returns.

As the boom takes hold, prices climb as more investors enter the market, driven by fear of missing out on further gains. That leads to euphoria, where prices skyrocket at a seemingly illogical rate. Profit-taking follows when investors begin to worry that a bubble may indeed be forming, and some begin to sell to protect their profits from what they see as the eminent crash.

That brings on the final phase—panic. This occurs when the masses realize the market is way overvalued and rush to sell off their positions at the same time, leading to a crash or drastic declines in asset prices.

How Long Does It Take for a Bubble Cycle to Play Out?

“The market can stay irrational longer than you can stay solvent” is an oft-cited quote attributed to famous economist John Maynard Keynes. Applying that rationale, it’s clear stock market bubbles can go on for a long time, inflating for many years in some cases as investors reach for reasons why market prices really do represent the value of assets.

For example, some analysts contend we’ve been in a Treasury market bubble for decades, fueled by the Federal Reserve slashing benchmark interest rates to near zero. In recent years, we’ve seen manias of sorts in cryptocurrencies and cannabis stocks.

Despite the long periods it can take to expand a market bubble, the bursting often happens quickly. What makes bubbles so dangerous is we often don’t realize when we’re in one, as investors find ways to convince themselves that a market’s prices are justified. It’s easy to get caught up in emotions and overlook the facts that should be guiding investing decisions.

What Indicators Can Investors Track to Watch for Possible Bubbles Forming?

Equity valuation benchmarks such as price-to-earnings (P/E) ratios can help investors get a handle on whether individual stocks or a broader market are “cheap” or “expensive” relative to history. P/E ratios are based on earnings per share, usually either the actual reported earnings for the previous 12 months or estimated earnings for the next 12.

The trailing P/E ratio for the S&P 500 index (SPX), for example, ranged from 29 to 31 in September and October 2020, making U.S. large-cap stocks appear relatively expensive (from 2014–19, the ratio was in the 18 to 24 range, according to data from the S&P Dow Jones Indices).

Technical indicators can also be helpful tools. For instance, many market professionals watch the 200-day simple moving average for clues on whether a longer-term price uptrend remains intact or if prices are coming out of a downtrend. Another chart tool, the Relative Strength Index (RSI), can provide clues as to when a market may be overbought.

Still, technical indicators and valuation metrics can stay at what would seem to be elevated levels for a long time and aren’t foolproof measures to avoid market bubbles.

How Can Long-Term Investors Protect Themselves from Bubbles?

Rebalancing and diversification are the cornerstones of sound, long-term portfolio management, and these principles are just as relevant in helping investors mitigate or minimize the impact of stock market bubbles. The limitation of traditional portfolio ideas, like asset allocation, diversification, and rebalancing, is that a market crash can drag down the entire market. Does the bursting of a bubble only harm the stocks directly in the bubble, or does the burst trigger a broad market crash?

These steps involve assessing your risk tolerance and mapping out long-term financial goals, then setting your allocations accordingly among asset classes—for example, a specific proportion of your portfolio in equities, another piece devoted to Treasuries, muni bonds, corporate bonds, and other fixed income instruments, and a slice in cash.

Stick with such a plan and you establish guideposts and signals for when it might be the right time to take profits on a position that’s appreciated and shift that into another area. Part of the idea is to avoid becoming too exposed to any one asset or asset class or jumping into a bursting bubble thinking you’re buying a dip. A long-term investor might also consider “alternative” assets, such as commodities, that have limited correlation to the broader stock market but have greater and unique risks of their own.

It’s also important to keep emotions in check and avoid snap decisions you may later regret. One handy tool for managing emotions is the stop order, which, placed in advance, will automatically sell a position once it declines by a predetermined percentage. Placing such stop orders can help investors avoid missing an opportunity to sell as a bubble is bursting. Just remember that once triggered, a stop order competes with other incoming orders, so if the market is in a free fall, you might not get filled at or near the stop price.







The Bottom Line on Market Bubbles

Stock market bubbles can feel great on the way up, but they feel degrees worse when they burst. But it’s also worth noting that, on a long enough timeline, many stocks, industries, and asset classes that were previously “bubbled” have made a resurgence—railroads, real estate, and even cryptocurrency, for example. The Nasdaq eventually made new highs after the dot-com era. Although many of those original dot-coms burst into thin air, those that survived—companies like Amazon (AMZN) and Qualcomm (QCOM)—carried on.

With market bubbles, the underlying narrative is based on a long-term trend that valuations get out of whack. The trick is to get the long-term exposure to areas of growth without getting swept up in the bubble.

But not tulips. They’re still below that high set in 1637.

For gauging the health of the economy, there’s no place like home. Housing market data has long been scrutinized by professional investors and traders seeking clues to the economy’s direction. Certain numbers, like housing starts and existing home sales, can move equity, bond, and commodity prices. Retail investors can similarly incorporate an understanding of housing numbers into trading decisions or portfolio strategy.

Housing, particularly residential real estate, is a critical leading economic and market indicator. Housing statistics issued by the government can offer a window into many related industries and business sectors. These include banking, construction, energy, technology, and home improvement retailers.

As the COVID-19 pandemic illustrated, home is much more than a place to hang your hat; it’s increasingly where we work, play, teach, and learn. Investors can study the housing market in many ways: through government housing reports, stocks of homebuilders, and so-called real estate investment trusts (REITs). Here’s a primer on the housing market and some of the most widely followed housing indicators.

Why Is Housing Market Data Important?

Follow the money. By year-end 2021, the total of the U.S. housing market was more than $43 trillion, up $6.9 trillion in 2021 alone, according to Zillow Group. People spend sizable amounts on their homes and what they put in them, and because consumer spending accounts for upward of 70% of U.S. gross domestic product (GDP), housing can be a bellwether of retail sales and other economic activity months in advance.

It’s also important to know that housing is typically among the first sectors to weaken when the economy approaches recession and also one of the first to bounce back when the economy turns up.

Housing Starts and Building Permits

Many housing statistics are considered lagging indicators because they reflect completed transactions from weeks or months before. However, housing starts and building permits are two widely watched backward-looking stats because they can identify a ripple effect of housing growth or retreat in particular regions or time frames.

Housing starts are both a production harbinger for the economy and a barometer of builder sentiment. Tracking starts and permits together offer investors a great indicator for real economic activity.

Starts are registered at the onset of construction (defined as the beginning of excavation of the foundation) of a house or apartment building. Building permits, registered with a government authority, typically precede starts by a month or two. Both starts and permits are released in the same monthly report from the U.S. Census Bureau, and numbers are expressed in terms of seasonally adjusted annual rates.

During 2022’s inflationary spike affecting housing spending in general, U.S. housing starts were creating fireworks. May housing starts were down 3.5% year to year and a full 14.4% below April 2022 figures. Permits tumbled 7% to a rate of 1.695 million units. During the early months of the COVID-19 pandemic, housing starts saw volatility as well. You can find housing starts data on the thinkorswim® platform. Select the Analyze tab > Economic Data, and then enter HOUST:FRED in the symbol box (see figure 1).

housing data housing starts tt210315 f1

FIGURE 1: PANDEMIC-ERA STARTS. Housing starts decreased in January 2021 after a significant rise since April 2020. You can find hundreds of housing data points on thinkorswim on the Economic Data tab, which can be found under the Analyze tab. Data source: the Federal Reserve FRED database. Chart source: The thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results. FRED® is a registered trademark of the Federal Reserve Bank of St. Louis. The Federal Reserve Bank of St. Louis does not sponsor or endorse and is not affiliated with TD Ameritrade.

New Home Sales and Existing Home Sales

New home sales, also compiled by the Census Bureau, measure the number of newly constructed homes with a “committed” sale during a month. Existing home sales (also known as home resales) from the National Association of Realtors are the number of previously constructed homes, condominiums, and co-ops for which a sale closed during the month.

New home sales make up only about 10% of all U.S. home sales, but they have an outsized economic impact because new homes create construction jobs, investment activity, and related spending that helps the economy.

In May, the National Association of Realtors reported existing-home sales fell 3.4% from the previous month and 8.6% year to year.

S&P CoreLogic Case-Shiller Home Price Indexes

Home price trends over the short and longer term influence consumer sentiment and behavior and factor it in to broader economic health. That’s one reason the S&P CoreLogic Case-Shiller readings are among the most widely followed U.S. residential real estate price benchmarks.

S&P CoreLogic Case-Shiller Home Price Indexes track monthly changes in the value of residential real estate (based on existing home prices) in 20 U.S. metropolitan regions and the country as a whole.

Hindsight may be 20/20, but history is worth remembering. The S&P CoreLogic Case-Shiller Home Price Index climbed steadily from the mid-1990s to mid-2000s before hitting a then-peak in the summer of 2006. A real-estate bubble was about to burst, triggering the Great Recession of 2007–09.

In June 2022, the S&P CoreLogic Case-Shiller 20-city composite index rose 21.2% year over year. To get the Case-Shiller data on thinkorswim, under the Analyze tab, select Economic Data > Prices > House Price Indexes. From there, you can access all the Case-Shiller data—national, regional, and local—and hundreds of other housing numbers (see figure 2).

case schiller june 2022

FIGURE 2: TRACKING RESIDENTIAL REAL ESTATE VALUE. Pull up the S&P CoreLogic Case-Shiller Index, plus other housing data points such as existing home sales, from the Economic Data tab in thinkorswim. Data source: the Federal Reserve FRED database. Chart source: The thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results. FRED® is a registered trademark of the Federal Reserve Bank of St. Louis. The Federal Reserve Bank of St. Louis does not sponsor or endorse and is not affiliated with TD Ameritrade.

Homebuilders, Home Improvement, and Other Housing-Related Stocks

Publicly traded homebuilders are among the most direct ways to gain exposure to, or at least follow, the housing market. These companies include D.R. Horton (DHI), LGI Homes (LGIH), Lennar (LEN), PulteGroup (PHM), and Toll Brothers (TOL).

Other housing-related sectors are more about the stuff people put inside their homes, including home improvement chains like Home Depot (HD) and Lowe’s (LOW), as well as appliance, furniture, or electronics retailers, such as Best Buy (BBY), Laz-Y-Boy (LZB), and Whirlpool (WHR). Another potentially intriguing angle includes publicly traded REITs, several of which are linked to the residential sector.

How Do Markets React to Housing Data?

Housing data doesn’t carry the same economic heft as, say, unemployment figures for price impact on bonds and equities, but it can be very useful when economic cycles are turning.

Stronger-than-expected housing starts can help trigger a rally in stock prices based on expectations that accelerating economic growth related to new homes and neighborhoods springing up will push corporate earnings higher. At the same time, Treasury prices may dip over concerns about rising inflation and/or higher interest rates related to monetary tightening/loosening by the Federal Reserve (bond prices move in the opposite direction of rates).

Conversely, weaker-than-expected starts may push equity prices lower and bond prices higher, amid prospects for a slower economy and lower interest rates.

Whether you’re an active trader, long-term investor, retiree, or anything in between, you’re likely connected to the housing market as an owner or renter. For many Americans, home equity represents a large chunk of the nest egg. And from a fundamental standpoint, housing market trends are directly connected to consumer spending, which accounts for roughly 70% of the economy.

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