Tags: bubble | stock | tulip | risk

How to Tell When Stocks Are in a Bubble

By    |   Wednesday, 28 Jan 2015 08:10 AM

One question seems to drive investors to the verge of insanity — "Are we in a bubble?" Analysts have come with up with a number of ways to answer this question, but many are based on traditional valuation tools and aren't very helpful. For example, price-earnings (P/E) ratios have been higher than average for most of the past 25 years. This indicator just doesn't work well for bubble spotting.

Bubbles actually occur when investors change the way they think about risk. When a bubble develops, there are always new ways to invest that increase the amount of risk an average investor can incur. This signal has occurred in every bubble for the past 400 years.

In 1635, according to market historians, Dutch traders began buying and selling promissory notes on tulips. A market for tulip bulbs had existed in Holland since about the 1570s. But in 1635, the market changed from physical bulbs to pieces of paper that described the appearance of the flower, where it was planted and the date it should be ready to be dug up so that the buyer could take physical possession of the flower. These papers, tulip promissory notes, represented a new way for investors to lose money.

Ever since, financiers have invented new ways to take money from investors during market bubbles.

More recent examples of bubbles can be found in the U.S. In the 1920s, unit investment trusts were created to allow investors to make a small down payment on a fund that traded stocks on margin. In the 1990s, business plans for Internet startups were transformed into shares of dot.com companies. In the early 2000s, mortgages were transformed into collateralized mortgaged obligations and other derivatives.

A bubble occurs when the market structure changes so that hopes and dreams are freely tradable. For now, leveraged exchange-traded fund products show signs of increasing popularity. When these products become mainstream, we will have the confirmation of a bubble. Until then, we simply have an expensive and risky stock market.

© 2017 Newsmax Finance. All rights reserved.

 
1Like our page
2Share
MichaelCarr
One question seems to drive investors to the verge of insanity — "Are we in a bubble?" Analysts have come with up with a number of ways to answer this question, but many are based on traditional valuation tools and aren't very helpful.
bubble, stock, tulip, risk
334
2015-10-28
Wednesday, 28 Jan 2015 08:10 AM
Newsmax Inc.
 

Newsmax, Moneynews, Newsmax Health, and Independent. American. are registered trademarks of Newsmax Media, Inc. Newsmax TV, and Newsmax World are trademarks of Newsmax Media, Inc.

NEWSMAX.COM
MONEYNEWS.COM
© Newsmax Media, Inc.
All Rights Reserved