Is the Stock Market in a Bubble?

Three warning signs to watch for

Todd Lincoln, MBA
Investor’s Handbook

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Photo by Lanju Fotografie on Unsplash

The promise of big gains in the stock market can sometimes lead to irrational exuberance and the formation of bubbles. These bubbles occur when stock prices become significantly overvalued due to speculative trading rather than being driven by underlying fundamentals such as company earnings and financial health.

While timing the market is a hard game to win at, it can be helpful to watch for warning signs of a bubble in order to safeguard their portfolios from potential losses.

Let’s look at three key indicators of a stock market bubble.

Excessive Valuations

A hallmark characteristic of a bubble is excessive valuations. This occurs when stock prices significantly deviate from their underlying fundamentals, such as earnings, dividends, and book value. In a bubble scenario, stocks may trade at historically high price-to-earnings (P/E) ratios or price-to-sales (P/S) ratios, indicating that investors are willing to pay premium prices for shares relative to the company’s actual performance.

Looking at the market as a whole, metrics such as the cyclically adjusted price-to-earnings (CAPE) ratio, which compares current stock prices to average earnings over a long-term period, can offer insights into…

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Todd Lincoln, MBA
Investor’s Handbook

Stock-market investor, battle-scarred entrepreneur, and fireside philosopher. Creator of Investor’s Handbook: https://medium.com/the-investors-handbook