Be fearful when others are greedy. Be greedy when others are fearful. — Warren Buffett

Trade wars, insurrection, and new virus mutations spreading quickly around the globe have done little to slow investor enthusiasm. Retail investors continue to flock into stocks with remarkable gusto. If you’re concerned stock prices might be overvalued, you’re not crazy. Experienced economists warn we are almost certainly in the middle of a massive Federal Reserve liquidity bubble.

The problem is if you agree we are in a bubble, then how can the average investor determine when that bubble is coming to an end? The truth is there is no way to know for sure. Unfortunately, historical examples of irrational exuberance have demonstrated bubbles can inflate for surprisingly long periods of time.

However, if we look back at the biggest stock market bubbles over the last century, there are three interlinking events that repeat again and again — inexperienced investors piling into the markets, wide-spread exuberance, and a consensus that the stock market won’t crash.

In this article:

1. Retail investors continue to flood into ever-riskier investments
2. An ever-increasing number of stocks are wildly detached from underlying fundamentals
3. The vast majority of investors are betting on the bull continuing
4. How this bubble might end

The Dunning-Kruger Effect

The Marx Brothers were big comedy stars in 1929. They started their careers in vaudeville but quickly moved into the rapidly expanding movie industry. By 1929, Groucho Marx had amassed a small fortune of around $250,000 through a combination of savings and investments. However, like many new investors in the roaring 20s, Groucho was quickly realizing acting was a whole lot more work and a whole lot less financially rewarding than investing in the stock market.

Every day (Groucho) would go in and he’d look on the big board and he’d see that his stock had climbed X number of prices, and he had made several thousand dollars without lifting a finger. And he thought, well, this is easy. — Maury Klein, professor of history and the author of “Rainbow’s End: The Crash of 1929.”

But like all stock market bubbles, the 1920s bubble suddenly came to an end. Groucho lost everything in the crash of 1929, at the age of 40. According to historians, the tremendous financial loss affected Groucho psychologically for many years. In the 1932 movie Horse Feathers, Groucho’s character, Professor Wagstaff used the word ‘Anaconda’ as a curse.

Professor Wagstaff’s exclamation, “Jumpin’ anaconda!” is actually a reference to a company, Anaconda Copper, in which Groucho Marx had invested heavily. When the stock market crash of 1929 occurred, Marx lost several hundred thousand dollars, hence the curse word in the movie. — IMDB

Unfortunately, Groucho was suffering from what psychologists today call the Dunning-Kruger Effect. The Dunning-Kruger Effect is when someone knows so little about a subject, they don’t even realize how little they know, leading to an over-estimation of personal ability. Unfortunately, just like Groucho Marx experienced in the 1920s, we again are seeing large numbers of inexperienced investors jump into the stock market for the first time.

Personally, I think it’s great younger and first-timers give investing a try. Prudent and carefully planned investing is a great way to ensure long-term financial security. However, inexperienced investors today are investing more aggressively than seasoned pros without ever having faced a multi-year bear market — a classic example of the Dunning-Krugger Effect in action.

There are articles about people giving up their day jobs to become full-time traders. There are options trading and swing trading video tutorials all over YouTube. Options contracts have exploded and now social media savvy investors are working through mediums like Reddit to move the price of stocks like Gamestop. Bored with sideways moving technology stocks like Amazon, investors are piling into progressively more aggressive investments — an excellent indicator we could be approaching the end of the current stock market bubble.

Cognitive dissonance

In the 70s much of the world experienced stagflation. Central banks quickly raised interest rates in an attempt to break stagflation. Higher interest rates made investment products like guaranteed investment certificates and bonds very attractive. Investors were earning excellent returns with very little risk. As stagflation ended, interest rates started falling. This helped to increase the value of fixed income even further. But eventually, when interest rates started getting too low, investors started looking for more yield.

Investors found that yield in the stock market and particularly in mutual funds. Throughout the 90s, investors poured into mutual funds. At one dealer I used to work for years ago, the older brokers told me of a time when there was really no need to look for new investors. Investors new to equity investing were so desperate to get into mutual funds, they would call the brokers.

Then the internet came along. Investors were bored with their blue-chip investments. Suddenly everyone wanted a piece of the future. Everyone wanted technology funds, biotech funds, or small-cap funds — the higher the risk, the better investors liked them.

By the time 1999 rolled around, we were so busy making purchases and opening new accounts we had to double our back-office administration to keep up with demand. Prices of technology stocks sky-rocketed to impossible levels. Even companies that were losing millions of dollars a year only went straight up in price — both investors and market insiders were ecstatic.

In some ways reminiscent of 1999, investors are again being pushed into stocks to find yield. However, time around the ultra-low interest rates and the flood of new investors are the direct result of an unexpected pandemic. Similar to 1929, we have too much money chasing too few stocks to prices that no longer reflect anything close to reality, and no one seems to think the good times are going to end.

Cognitive dissonance refers to a situation involving conflicting attitudes, beliefs, or behaviors. This produces a feeling of mental discomfort leading to an alteration in one of the attitudes, beliefs, or behaviors to reduce the discomfort and restore balance.

It should be clear to everyone that much of the stock market is extremely frothy, yet brokerage account openings smashed all records in 2020 and the trend appears to be continuing in 2021. Investors continue to plow money into stocks and cryptocurrency. Far too many people continue to chant the re-hashed investing myth, this time it’s different.

Investors would do well to remember stock market bubbles are real and they all eventually come to an end. Investors who believe new business models will keep stock prices moving higher indefinitely are suffering from the same cognitive dissonance investors have suffered from in every preceding stock market bubble. Investors refusing to square current valuations with the real-world fundamentals of corporations is an excellent indicator we could be approaching the end of the current stock market bubble.

In both eras, some of the country’s most respected financial experts became stock-market cheerleaders, telling investors that new technologies and better ways of doing business would keep share prices climbing indefinitely. — Wall Street Journal, October 27, 2002 discussing similarities between 1929 and 1999 stock market crashes

Confirmation bias

Comments on YouTube videos and on investing message boards are full of bullish comments and bearish comments are met with hostility. It seems if you only wish hard enough and don’t jinx it with negative thoughts, the stock market will continue to relentlessly rise.

In some ways reminiscent of 1999 and 1929, we have many analysts in 2021 insisting stock prices aren’t too high and instead attack investors for not being even more heavily invested. They make arguments that the economy has somehow changed and valuations no longer matter.

Apparently, the vast majority of investors seem to agree that stocks have more room to run. For example, the City Panic/Euphoria Sentiment Index is now higher than the peak of the bubble in 2000.

CNN’s Fear & Greed Index is currently at 71, which doesn’t sound so bad until you look at the underlying measurements. Stock price breadth, market momentum, junk bond demand, safe-haven demand, and stock price strength are all at Extreme Greed levels. The index would be higher but put and call option volume currently signals Extreme Fear.

If virtually everyone you talk to think stocks are going straight up, it’s an excellent indicator we could be approaching the end of the current stock market bubble.

During the last five trading days, volume in put options has lagged volume in call options by 51.87% as investors make bullish bets in their portfolios. However, this is still among the highest levels of put buying seen during the last two years, indicating extreme fear on the part of investors. — CNN Business

Final thoughts

Like many bubbles before it, the current stock market bubble is likely to drain away more slowly than it inflated. As always, there will be short, sharp corrections down followed by short relief rallies, before once again falling to another new low. The full unwinding will likely be quite slow — perhaps taking many months or even years. All the stop-loss orders and option selling that seemed so easy as the market relentlessly climbed, will suddenly turn against the inexperienced investor.

As more and more investors get burned as the market continues to correct, many investors will leave the markets, some permanently like they did in 1999 — disgusted with trading and the stock market. The money will flow to less risky investments, like property and fixed income (as interest rates begin rising again). This outflow will put even more downward pressure on the stock market, as it always has every time we’ve seen a stock market bubble burst.

Perhaps an even better question to ask is, how far could stock prices ultimately retreat? How low the markets go will depend on the timing of the Federal Reserve and central banks around the world. Pull back liquidity too quickly and the economy may reverse back toward recession. Pull back liquidy too late and a second Japan bubble economy could be triggered, potentially leaving investors with another ‘lost decade’. Unfortunately, history suggests central banks often get the timing wrong.

Although we can’t know the future, this might be an excellent time to review your portfolio and at least think about rebalancing or re-weighting your investments, just in case. If you agree timing the stock market is a fool's game… how about the Federal Reserve trying to time the world’s largest economy?

Disclosure — I have no positions in any of the stocks referenced in this article. Please seek professional advice before making any investment decisions.