Take heed: why everything from ESG stocks to used car prices are in bubble

The stock market has been on a wild tear. We have just experienced the longest bull market in history, with the Nasdaq increasing over 100% and the S&P 500 and Dow up 80% respectively since the crash of March 2020.

But it isn’t just the stock market. Bizarre commodities such as corn, NFTs, playing cards, and even used car prices are soaring. These extreme prices have lured big investors into the assets, enraptured by the idea of profiting like everyone else. Most recently, for example, the NBA began selling NFTs. But timing is important. Get in too late and you could wind up losing your shirt.

The signs of bubbles are ever-present in today’s market - from commodities to EV’s and, unfortunately, even within the ESG industry. As an avid fan of value investors like Michael Burry, who recently warned that the stock market is ‘ dancing on a knife’s edge,’ and Warren Buffet, whose ‘Buffet Indicator’ has risen to levels not seen since the dotcom boom, I’ve been closely following the escalating prices and listening to their heed.  

Further, the principles that renowned investor Benjamin Graham built his investment strategy around have led me to question if this market run-up is set to last. Graham grounded his thesis in value, margins of safety, and being careful to not get involved in speculation. Applying these principles to present-day investing demonstrates how overvalued equities have become.

What is an economic bubble?

To understand what to do about economic bubbles, we must start by defining them. According to Investopedia, an economic bubble is “a situation where the price for something exceeds its fundamental value by a large margin.” Economic bubbles can materialize in anything from equities to industries like real estate or cryptocurrencies, the credit market, and even commodities.

Bubbles can be caused by either the promise of a new product or innovation, low interest rates, or commodity shortages. In these circumstances, investors become captivated by speculation, which fuel price surges. The dramatic price increase will then be followed by a massive selloff and a drastic drop in value when the bubble “pops.” 

Unfortunately, most don’t realize the signs of an economic bubble until it’s too late. The biggest examples of this include the 2008 housing collapse, the 2000 dotcom boom, and the economic impact of the “roaring twenties,” all of which led to severe and devastating economic recessions.

Yet, some have been successful in identifying the warning signs early on and have even profited from them. For example, famed investor Michael Burry made $100 million himself and $750 million in profits for his investors for his bet on the housing market collapse. This tells us it’s certainly possible to stay ahead of market crashes so long as you pay close attention to the signs and don’t fall into the enticing traps of bubbles.

How to spot an economic bubble

Now that we know what an economic bubble is, it’s essential to understand how to spot one. In Stabilizing an Unstable Economy (1986) economist Hyman P. Minsky described the 5 stages of an economic bubble: displacement, boom, euphoria, and profit-taking. Here are how these stages play out:  

First, displacement occurs. Individuals become captivated by an asset or commodity due to its promise to revolutionize an industry. One example of this is the innovation around the internet, which fueled the dotcom bubble. Then there is a boom. Prices begin to rise, and the industry attracts vast media attention. The rise in media coverage brings even more capital into the industry, fueling speculation due to fear of missing out. Euphoria hits. Evaluations reach unexplainable levels and investors believe that no matter how high the price of the asset goes there will always be another consumer that will purchase it. The price continues to snowball, which is driven by psychological concepts like herd mentality, short-term thinking, and cognitive dissonance. With the rising prices, smart investors will begin profit-taking. Money leaves the market, slowly at first. The dropping price then causes a panic. In this stage, money bleeds out of the market, leading to devastating losses for many investors.

The phases outlined by Minsky showcase the process for how a bubble forms and pops, helping us grasp some of the warning signs. In addition to understanding this process, another useful tool to look at is the Cyclically Adjusted Price Earnings Ratio (CAPE) of a company or asset. CAPE was formulated by Benjamin Graham, David Dodd, and Robert Shiller and is a take on the price-to-earnings ratio. A high CAPE ratio typically correlates with market crashes.

Finally, as mentioned above, the Buffet Indicator is another helpful tool in gauging how the U.S. stock market’s value compares to the global market. Anything over 100% on the Buffett Indicator suggests the market is greatly overvalued.

How to protect your investments

Now that we know the stages of an economic bubble and some elements to look out for, the following is what you should do if you feel that one or more of your investments are in one:

1.     Diversify. If you feel what you are invested in has reached unsustainable highs, make sure you are continuing to invest in other stocks or an industry that is showing promise but isn’t experiencing the same frenzy. I highly suggest concentrating your focus on a few value stocks or a safe asset like a bond in the event that the bubble pops.

2.     Take out some of it. If you like the investment and aren’t willing to part with it just yet, take some money out, whether that be ½ or ¼ of your investment. Most recently, I followed this strategy for my investment in the streaming platform Roku. After the stock soared 160% higher from my original purchase price and then began crashing, I took half of my investment out but left the rest in as I still believe in the future of the company.

3.     Keep an eye on the asset. If the equity begins crashing drastically, you’ll want to be able to pull out of the investment quickly.  

Another option is to hedge your bet on the investment. One way to do this is to purchase a put option on the stock. In the event that your investment does plummet, you will have shielded your loss.

In summary.

Generally speaking, the market has become greatly overvalued. If you are actively investing right now proceed with caution, especially in anything that has risen in value very quickly, has high trading volume, or is offering the promise of making a “quick buck.” Following the thesis of the great Benjamin Graham, often the best investments are the ones that are undervalued and overlooked so make sure you are investing time and resources to find those.