The meteoric rise of a handful of tech stocks has many investors wondering whether the stock market is in a bubble. While obvious in retrospect, bubbles are notoriously difficult to recognize when you’re in one.
Here’s what we do know: The so-called Magnificent Seven (Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla) led the S&P 500 charge upward in 2023. And so far in 2024, the broad benchmark’s gains have been ferocious. But some of the Magnificent Seven are already taking a breather or perhaps even deflating.
There’s an asset bubble almost every decade. Most are driven by the arrival of a life-changing technology (the computer, the internet, artificial intelligence) or the belief that there’s a permanent scarcity of goods.
“Bubbles usually follow a period of easy money,” much like we’ve seen in recent years, says Francois Trahan, an economist and president of the Macro Institute. That, Trahan says, “leads to a rebounding economy and a feeling of prosperity. That’s usually when speculation kicks in. I’d say we have followed this historical pattern very well so far.”
Past market bubbles have shared three key traits as they neared extremes. First, there’s a sizable gap between the price of the asset that’s bubbling up and its fundamental value. Second, the buying frenzy expands to include everyone (your mail carrier, say, or your mother). And third, there is rampant speculation, often amplified by trading with borrowed funds, as with margin accounts.
But the biggest common denominator of all bubbles is greed and the prevailing belief that soaring prices are justified because “this time things are different,” says Trahan.
Before a bubble pops, price volatility rises substantially as assets trade more on momentum and less on fundamental measures. The party typically ends after central banks raise interest rates.
There are usually ample signs that an investment craze is overheating. Declining earnings estimates is one “warning signal,” says Sam Stovall, chief investment strategist at CFRA Research. Watch for less-than-encouraging company guidance for future quarters.
“If we can hear optimism from company managers regarding future growth and we see numbers coming in better than expected,” that would be a sign that the good times will continue, says Stovall. But when the talk turns less confident, it might be time to leave the party.
When a bubble deflates, it’s often unclear whether the market is experiencing a pullback (a 5–9.9 percent decline), a correction (a 10–19.9 percent drop), or the start of a bear market (a decline of 20 percent or more), says Stovall.
Some investors view early declines as buying opportunities, only to see prices fall further. Confusion persists until everything starts dropping in price, and then it often feels as if there’s no place to hide.
So, where are we now? Is it time to cut and run? Or should we continue to invest in this rally? Savita Subramanian, head of U.S. equity strategy at BofA Global Research, remains optimistic. “The S&P 500 lacks signs of a bubble,” she says. “In our view, this bull market has legs.”
But Stovall, who is bullish for the long term, nonetheless sees “tiny bubbles” that are beginning to concern him.
This is a good time to remind yourself of time-honored investing tenets, such as diversification.
