How to Play Stock Market Bubbles

Know the signs of a stock market bubble forming.

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The stock market bubble and the more recent housing bubble are evidence of the stock market’s irrationality. Investor enthusiasm can turn into frenzied buying as stock prices reach one new high after another. Unrealistic expectations and overbought market conditions spell disaster when the bubble bursts. Smart investors watch for the signs, sell their stock for a profit, and get out of the way of the inevitable market crash.

Step 1

Understand the life cycle of a stock market bubble. It starts with a new idea that has a potential for big profits. Investors start buying into these companies and the stock price goes up, which attracts the interest of new buyers. This in turn pushes the stock price higher, which kicks off a new round of buying. The stock price jumps to unheard-of levels and keeps going. But when supply catches up to demand or the new idea proves a bust, stock prices collapse. The bubble bursts as investors panic and sell their stock at fire-sale prices.

Step 2

Know what kicks off a bubble. Look for new fads, ideas or developments that would attract investors. The bubble needs the right economic conditions of low interest rates, industry deregulation or lax regulations, and a surplus of cash. Pay attention to how much coverage the financial news media give the new bubble companies, especially to reports of increased stock buying in the target companies.

Step 3

Use technical analysis to help determine your entry price. Confirm the strength of the trend by using volume indicators and trend analysis. Momentum investing, when investors chase stocks in search of quick profits, replaces fundamental analysis. Price-to-earnings ratios have no meaning when stocks are caught up in a bubble. Go long and plan to hold your position. Stock prices are a roller coaster ride of shooting up, falling back to consolidate, then shooting up even higher. Don’t try to call price tops.

Step 4

Recognize the warning signs of a bubble getting ready to burst. Examples: Stock prices have jumped 50 percent or more in a short time but the company business model does not support the price move. The U.S. Federal Reserve Board raises interest rates to contract the money supply and cool off an overheated economy. The money supply dries up and buying dramatically slows. When traders stop buying, prices start falling. Frantic shareholders sell, driving stock prices even lower, which sets off another wave of panicked selling. This confirms that the bubble has burst.