With stock indices delivering historic highs, many investors fear a stock market bubble is forming or about to burst. We’ll explain how you can weather the storm
While many headlines suggest a stock market bubble is coming or already growing, some experts believe otherwise –– at least for now.
“Speaking for the overall market, we do not see that it is in a bubble,” said Peter Jones, CFA, senior vice president of equity research and portfolio management at Ferguson Wellman. “In light of 2021 earnings estimates, stocks are not trading at unprecedented valuation, especially when compared to historically low interest rates. Lower rates equal higher fair valuation for stocks. However, we are seeing some extreme price movements, and no doubt growth stocks are running hot compared to value stocks.”
Stock market bubbles occur when stock prices soar dramatically before plunging into chaos. And we have seen some sharp spikes.
The S&P 500 climbed by 16% in 2020 and the Nasdaq soared by 43%. Both flew past historic returns, and the stock market has recovered losses seen in the early days of the COVID-19 pandemic. Plus, individual stocks saw nearly unprecedented gains. Tesla, for instance, saw its stock price grow 20 times in the past 18 months and now holds a market capitalization five times that of GM, Ford, Toyota and BMW combined.
Moreover, the popularity of commission-free brokerage platforms like Robinhood and Stash has created novice day traders who may move markets.
According to an E-Trade survey of active investors with at least $10,000 in brokerage accounts, 66% believe the stock market is either fully or somewhat in a bubble. Meanwhile, 26% believe we’re “approaching a market bubble.”
But rather than speculate over whether we’re approaching a stock market bubble and when it could burst, you can benefit more from taking some precautions to prepare for one and even profit from it.
If you fear a stock market bubble is on the horizon, consider these steps:
Assess your risk and rebalance your portfolio
Reviewing your portfolio and making adjustments if needed is key to any investing strategy. Take a look at yours and see if it still matches your risk tolerance.
Following a stock market bubble, you can expect stocks to drop drastically. If you don’t have liquid reserves ready to support you if your stock holdings suffer, it may be time to readjust.
Generally speaking, large-cap stocks from established companies tend to be less risky than small-cap stocks from newer companies. These are often referred to as blue chip stocks. And mid-cap stocks typically fall somewhere in between on the risk scale. So if you have a low risk tolerance, consider shifting more of your asset allocation to large-cap stocks.
On the fixed-income side, US Treasury bonds are the safest. Next come municipal bonds, and finally corporate bonds.
Review your fund holdings
Investing in mutual funds and exchange-traded funds (ETFs) is a solid way to diversify your portfolio, but it’s important to look under the hood. Your funds may be heavily weighted toward stocks in a particular sector.
For instance, many high-performing funds devote much of their holdings to stocks like Amazon, Facebook and Google (Alphabet). But these are all in the tech sector. While these companies are among the largest in the world in terms of market value, they could see massive losses if a stock bubble originates in the tech sector. So be aware of how much your portfolio devotes to any particular sector, and make sure your risk tolerance is in line with it. Otherwise, it may help to rebalance your portfolio to make it more diversified.
Hedge against volatility
You can also protect your portfolio from a stock market bubble by turning to investments that don’t usually move in line with the overall market. In other words: If the market moves in one direction, these investments tend to move in the opposite direction.
One example is real estate. You can easily gain exposure to real estate by investing in real estate investment trusts (REITs).
You can also take a stab at beta investing. Beta is a mathematical unit that aims to measure the volatility of a stock relative to the overall market. A beta of one or more generally means it’s more volatile than the market.
So theoretically during a market downturn, a stock with a beta of more than one can be expected to drop more than the overall market. But if its beta is less than one, you can expect it to move in a direction opposite to the overall market.
Gold, for example, tends to have a beta of less than one because it typically moves inversely to the market.
Engage in trend investing
When it begins to dip. It involves predicting price movements based on past information and indicators. One example of a trend indicator would be the 200-day moving average of the S&P 500, which is a benchmark for overall market performance.
Following this trend over time may give you an indicator of when the market is expected to go down and when you may want to exit. According to a study by Cambria Quantitative Research, “Across 12 market bubbles, we find that a trend following system would have improved return while reducing volatility.”
Take advantage of research tools
Despite all the press, it’s impossible to predict a stock market bubble. But rather than spending time trying to figure out if one is around the corner, it’s best to prepare. You can benefit from moves like reassessing your risk tolerance, rebalancing your portfolio accordingly, and investing across different securities and sectors. Top stock trading platforms can help you do this by offering research tools. It can take some learning and practice but can ultimately generate profits.
To adjust your current portfolio, you’ll need to work through your broker. For new moves, you can consider these or other trading platforms.
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