A Bullish run or a Bubble About to Burst? Either way, you Should be Prepared
2020 will go down in history as one of the most significant years in the history of the financial markets. The coronavirus pandemic weighed on markets, causing them to dip to extremely deep lows, before completely turning around and reaching never-before-seen heights. And yet, as bullish as markets are today, there are also some signs suggesting that we are in a bubble, and therefore, investors should prepare accordingly. Keep reading to find out what you can do to be better prepared.
The Current State of Markets
On the surface, markets today, especially in the US, have never been better. At the time of writing, both the SPX500 and NASDAQ100 indices have hit fresh all-time highs, while the DJ30 has erased all losses suffered due to the coronavirus pandemic. August 2020 was particularly good, as these indices registered their best monthly gains in more than 30 years.
Markets are doing so well that it is very easy to forget that less than six months ago, markets around the world suffered a tremendous crash. With a global pandemic crippling the travel and leisure industries, global oil demand on the decline and rising geopolitical tensions between superpowers such as China and the US, markets have been battered from all directions and, at certain times, registered declines greater than those of the Great Depression and the Great Recession.
One of the reasons US markets have recovered so well is due to the Federal Reserve. The Fed did everything in its power to level the markets, including pumping money into the US economy and essentially becoming the largest investor in the world.
Stocks rise to Meteoric Values
While the broad indices indicate a market-wide recovery, the details may tell a different story. For example, the S&P 500 index, which is considered a reliable gauge of the health of the American economy, has been on the rise. However, when looking at its components, it is obvious that its bullish run was fuelled mostly by the five largest companies listed on it. The main questions investors should ask is if these stocks are really so valuable, or if they are extremely overvalued.
Apple is perhaps the most obvious example. It took the company 42 years to reach a valuation of $1 trillion. However, it took it just two more years to double that and reach a valuation of $2 trillion, becoming the most valuable publicly traded company in history. Even over shorter periods of time, its performance has been phenomenal: The price of a single AAPL share doubled within just five months this year, just before executing a four-for-one stock split.
Tesla is another stock worth mentioning, as the electric carmaker has shattered record after record in 2020. Following a monstrous 500% increase in value this year, Tesla became the most valuable automotive company in history and the seventh most valuable company in the world. While there is no doubt that Elon Musk’s brainchild is extremely innovative, the company’s production volumes are nowhere near those of less valuable automakers. Its price is no doubt driven by speculation — but the question remains: Is it overvalued or will it catch up to its current valuation?
Newer companies have also been able to benefit from the bullish market — and even from the coronavirus pandemic. Popular video conferencing service, Zoom is one of the clear winners: Throughout 2020, the company’s stock value grew sixfold, including a single-day 40% jump on the heels of its Q2 earnings report.
While some investors are optimistic and are certain the bullish trend will continue, others are concerned that the market may be overvalued and that essentially, this is a bubble.
Are we in a Bubble?
What is a market bubble? The simplest explanation for the term “bubble” is a market that is valued at a much higher rate than its actual worth. It is called a bubble because, like its real-life namesake, it is doomed to eventually burst. Economist Hyman P. Minsky outlined the five stages of a market bubble:
- Stage one: Displacement — a displacement occurs when investors are heavily influenced by new information, an innovation or a new paradigm. For example, the extremely low prices to which stocks fell during the coronavirus market crash, or the unprecedented measures taken by the Fed to keep markets afloat, which have prompted many investors to buy stocks.
- Stage two: Boom — this is when prices begin to rise rapidly, as a result of the previous step, attracting new investors and new investments into the market.
- Stage three: Euphoria — during this stage, investors tend to believe that they “can’t lose,” throw caution to the wind and pump more money into the market, causing prices to rise further.
- Stage four: Profit taking — some investors begin to fear that markets may be nearing their peak, and decide to sell many of their positions.
- Stage five: Panic — this is essentially the burst of the bubble, as many investors notice prices are beginning to drop and withdraw their money, causing prices to fall even further, resulting in crashing markets.
If we are, indeed, in a bubble, we can currently be anywhere between the second and fourth stages. However, there is no way to know for certain.
Reducing risk and Exposure
While the bursting bubble doomsday scenario is not a certainty, it is still a contingency for which investors need to prepare themselves. Therefore, it is paramount that responsible investors look into ways of reducing their current risk levels and minimise exposure to volatile prone assets:
- Leverage: One factor that can greatly increase the risk in financial markets is the use of leverage. The higher the leverage, the larger the risk. Therefore, you should consider lowering leverage when opening new positions. To learn more about what leverage is and how it works on eToro, read this.
- Diversification: Make sure to spread your equity across various assets and asset classes and hedge your investments with safe-haven assets. To read more about using diversification to lower risk, check out this chapter in the eToro Fintech Guide.
Trading and Investing Responsibly on eToro
During these interesting and uncertain times, here at eToro, we advocate responsibility first and foremost. This is the time for smart investors to shine, managing their equity intelligently and taking the necessary steps to protect themselves in case we are indeed in a bubble.
For those who are less certain as to how to prepare, we suggest sticking to the basics: Diversification, not using too much leverage, only investing in markets and instruments with which you are familiar, and perhaps most importantly: Trust logic over gut feelings.
In addition, please keep your eyes open for updates from eToro. We may employ certain measures, or introduce temporary restrictions and limitations, to protect our clients’ funds, as well as our own. Regardless of whether or not we are in a bubble, such a tremendous bullish rally should be approached with caution — so be mindful of your actions and protective of your funds.
Data above is accurate as of 3/9/20
A Bullish run or a Bubble About to Burst? Either way, you Should be Prepared from eToro.