The stock market’s recent surge has led many investors to question whether a bubble is forming. Bubbles are notoriously difficult to identify when you’re in the midst of one, but looking back, they become more obvious. In 2023, the so-called Magnificent Seven tech stocks (Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla) propelled the S&P 500 to new heights. The market’s gains have continued to be strong in 2024, although some of the Magnificent Seven stocks have started to show signs of slowing down.
Asset bubbles tend to occur every decade and are often driven by the emergence of groundbreaking technologies or the belief in scarcity. These bubbles usually follow a period of easy money, which leads to economic growth and a sense of prosperity. This environment sets the stage for speculation and investment frenzy. According to economist Francois Trahan, this historical pattern seems to be repeating itself.
As bubbles approach their peak, three key traits become apparent. First, there is a significant disconnect between the price of the asset and its fundamental value. Second, the buying frenzy expands beyond experienced investors to include everyday individuals. Finally, rampant speculation fueled by borrowed funds becomes rampant. Greed plays a central role in all bubbles, as people believe that soaring prices are justified because “this time things are different.”
Before a bubble bursts, price volatility increases as investments rely more on momentum than on fundamental measures. Typically, central banks raise interest rates, signaling the end of the party. There are usually warning signs that an investment craze is overheating, such as declining earnings estimates and less optimistic company guidance for future quarters.
Determining whether the market is experiencing a pullback, correction, or bear market during a bubble deflation can be challenging. Some investors view early declines as buying opportunities, only to see prices fall further. It’s not until prices across the board start dropping that panic sets in, and investors feel like there’s no safe place to hide.
So where do we stand now? Should investors cut and run, or continue to ride the rally? Savita Subramanian, head of U.S. equity strategy at BofA Global Research, remains optimistic, stating that the S&P 500 does not show signs of a bubble and that the bull market still has room to run. However, Sam Stovall, chief investment strategist at CFRA Research, sees “tiny bubbles” forming that are beginning to concern him.
During uncertain times like these, it’s essential to remember timeless investing principles, such as diversification. By spreading your investments across different asset classes and sectors, you can mitigate risks and potentially weather market downturns. While it’s impossible to predict with certainty whether a bubble will burst or how severe the consequences will be, staying informed and making informed decisions can help navigate the unpredictable nature of the stock market.
