When the stock market has been on an extended run-up, how do you know when it changes from a bull market to a bubble?
Of course one person’s bull market may be another investor’s bubble about to pop.
Still, it is important to be aware of how much “hot air” is heating up the market.
In a typical bull market, buyers outnumber sellers, which leads to rising stock prices as the buyers bid up the prices of shares to entice sellers.
If a stock is a good buy at $20 a share, is it still a good buy at $25 a share or $30 a share?
What is driving the interest in stocks?
Frequently, stocks become more attractive when a bear market has driven prices down.
A bear market occurs when there are more sellers than buyers. For a variety of reasons, people feel uncomfortable in stocks and want to cash out.
However, with more sellers than buyers, the sellers much reduce the price they will accept to attract buyers.
The “hot air” that pushes stocks up can come from a variety of sources.
In the late 1990s dot.com boom, investors wanted in on the ground floor of a new and exciting industry and they were willing to pay top dollar for the privilege.
Not surprisingly (at least in retrospect), when the shiny, new industry was slow to deliver promised profits, investors fled the stocks and the markets dropped – the Nasdaq by more than 50 percent.
Not all bubbles are driven by technology. The financial crisis, which began in 2008 following the collapse of the housing market, had many factors at its core.
One of those factors was low interest rates, which made speculating in real estate and mortgage-backed securities very profitable.
To prevent the crisis from becoming a disaster, the government dropped interest rates and pumped billions of dollars into the financial markets.
This helped fuel a bounce from the bottom of the market in March of 2009 that sent stocks soaring.
Virtually free money (thanks very low interest rates) helped fuel the soaring stock market.
At some point, the Fed will have to raise interest rates or risk inflation taking off.
When that happens, how will the stock market react? A rise in interest rates could be the pin that pops the stocks bubble.
Since the stock market always looks forward, there is a danger investors will pull back in anticipation of an interest rate change.
Your best strategy is to stick with a diversified portfolio that suits your tolerance for risk.
If you are comfortable with a mix of 60 percent stocks and 40 percent bonds, rebalance your portfolio at least once a year and may be sooner to keep that proportion.
Don’t try to guess where and when the market will correct itself.
