How to Detect a Financial Bubble?

Dear Reader,


There is a huge literature on how to detect a financial markets bubble. Many seem to claim a financial bubble can be detected only after the fact. I do not agree. Financial bubbles are quite obvious beforehand. The problem is, it is very difficult to pin down exactly when a financial bubble is going to burst, so one can protect his/hers assets or make money by buying put options or shorting the underlying asset.

There are various approaches in the financial research literature on how to detect a financial bubble. Some say you have to witness two standard deviations yearly change.

From my experience, the best way to detect a financial bubble is to examine the graph of the underlying asset. If on a 1 year or 5 year basis the underlying asset goes up by a steeper than a 45% angle, this is most certainly a bubble=temporary, if not long, a deviation from the asset's underlying fundamentals.

As John Maynard Keynes adeptly put it: "Markets can stay irrational longer than you can remain solvent."

So, when has a financial bubble popped. I define a bursting of an asset price bubble, if the price of the asset falls more than 30% or even better 40%. We have witnessed even larger falls of the main US and global stock market indices like DJIA, S&P 500 and Nasdaq like declines of more than 50% from their 2008 peaks. Recently many technology stock bubbles burst. Examples are GoPro, GroupON, Zynga, Snapchat and even Facebook recently.

So are DJIA, S&P 500 and Nasdaq Composite in a bubble territory currently or overvalued significantly based on their fundamentals? Yes, they are. I do expect a major correction of the major US and Western European stock market indices in 2021 at the latest. Since the bull market in the US was the longest on record I expect the following stock market slump to be deep, larger than 30% fall, and one of the longest in duration on record.

In such a period the buy and hold, value investing strategies that many leading investors as Warren Buffett embrace will not work. Actually, value investing has not worked for the past 10 years driven by the rally in technology stocks, which are momentum stocks. What will work in the coming stock market correction is timing the market and picking stocks for the short run and selling them in a short while when they reach short-term peaks.

Disaimer: The blogposts and comments on this blog and posts on social networks(Twitter, LinkedIn etc.) are not investment recommendation, are provided solely for informational purposes, and do not constitute an offer or solicitation to buy or sell any securities. The opinions expressed in the blogpost and posts on social networks(Twitter, LinkedIn etc.) are the author's and they in no way express the opinion or official position of the company where I am working currently!

Conflicts of interest: I may possess some of the securities,currencies or their derivatives mentioned in the blogpost and posts on social networks(Twitter, LinkedIn etc.)!

Kind regards,

Petar Posledovich