How To Dodge A Stock Market Bubble

There's a joke that goes like this - "Why was astrology invented? So economics would seem like an accurate science." For all the thousands of professionals tracking the stock markets and its vast multitude of indicators, it is surprising just how many times stock market bubbles have built up over the decades and wiped out the household savings of thousands of well-intentioned investors. In this article, we attempt to demystify the infamous 'stock market bubble' and provide you with a few simple tips to avoid getting stuck in one.

What Is A Stock Market Bubble?
Simply put, a stock market bubble is a sustained, irrational increase in stock prices over a period of time. The precise dynamics of a bubble are too complex, but it's a well-known fact that they are fueled by a combination of exuberance and foolhardiness, a sort of denial to consider facts in the harsh light of reality, and in many ways a mindless 'groupthink'. Benjamin Graham referred to a certain "Mr. Market" (in his classic text "The Intelligent Investor"), who is almost always either too optimistic or too pessimistic but rarely ever realistic. Almost as soon as stock markets reach dizzying heights as a result of over exuberance, they tend to fall prey to the 'house of cards' syndrome in which a single global or local event often topples stock prices from their peaks, leaving hapless retail investors tottering in their wake.

Sudip Bandyopadhyay, Group Chairman, Inditrade Capital Ltd. believes that the PE (Price to Earnings Ratio) of a stock or of the market as a whole may provide early warning signs of an impending market bubble. "A bubble like situation gets created in the market when valuations rise ahead of actual performance of the company and its future prospects. Amongst others, a retail investor should be careful about buying stocks which are at quoting at a very high PE multiple", he says.

History Does Repeat Itself
Sir John Templeton once famously said - "The four most dangerous words in investing are - this time it's different". While so called experts will tend to profess these four words vehemently even in overheated market scenarios, the truth is that when it comes to bubbles, history does repeat itself - and will continue doing so. Right from the Dutch tulip mania of the 1600's to the dot com bust in 2000, and more recently, the subprime mortgage crisis then sent markets into a tizzy in 2008, bubbles, unfortunately, are here to stay.

Bandyopadhyay concurs with the view that bubbles as a phenomenon aren't going away anytime soon, and investors are advised to be careful. "Market bubbles are a reality and for centuries, across the world, the stock markets have been through this cycle of bubbles and subsequent bursting of bubbles", he says. "From a retail investor's point of view, buying stocks only at a reasonable valuation can preserve their wealth"

The Anatomy Of A Bubble
A bubble takes root when investors fall in love with a new paradigm, such as an innovative new technology or historically low interest rates. Very quickly, this phase moves onto what is called a 'boom' phase - marked by widespread media attention and the so called 'fear of missing out on the opportunity of a lifetime' attracting new clutches of investors (read: speculators). The boom phase then gives way to raw, emotion fueled euphoria where rationality goes out the window. Prices move up far beyond what they ought to be, and people actually start justifying them. The next stage is the one in which smart investors start booking profits (this is probably as good an exit sign as ever), followed by a full blown, panic led selloff.

Bandyopadhyay believes that bubbles are primarily the outcome of irrational expectations coupled with an abundant supply of money. "Structurally, the market moves with future expectation and news flows. Unrealistic expectations based on misinterpretation of future prospects, coupled with abundant liquidity create bubbles. The bursting of bubbles happen when one of these assumptions (for instance, future performance or growth prospects) proves to be incorrect and/ or the liquidity situation changes" he says.

Watch Out For These Signs
Watch out for too many IPO's hitting the market at once. The primary market takes cues from the secondary markets; leading to a number of IPO's when the markets are bullish. Bandyopadhyay believes that retail investors should be selective about which IPO's to invest in. "Structurally, the above phenomenon is not detrimental to the interest of the investors, provided the IPOs are reasonably priced. Same cautionary steps (like stock selection) regarding selection of IPOs should be taken by the Investor", he advises.

Additionally, the PE (Price to Earnings) ratio of the NIFTY being well higher than the long term average is another warning sign.

Too much 'groupthink' and consensus amongst experts that the markets are headed up is another indicator of impending doom (albeit a surprising one). You'll be surprised to know how many experts were predicting a near future SENSEX level of 30,000 late in the year 2007.

In conclusion, Bandyopadhyay offers his expert view on the four things to keep in mind while picking stocks for the long term. "First - the background, credentials and track record of the Promoter. Second - the past performances and track record of the Company. Third - future prospects of the Industry in which the company is operating and the position of the Company in the Industry, And lastly, the Market valuation of the company", he advises.