3 Signs That We’re Heading Into a Stock Market Bubble

NEW YORK (TheStreet) -- As traditional investments reach new highs, attempts are made to identify the top of the market as well as drivers of excessive optimism.

The dot-come bubble of the 1990s is a classic example of a stock market bubble. This was primarily driven by speculation around the development of the Internet and associated businesses, which quickly caused markets to overlook fundamental metrics that, to a certain extent, define the health of a growing and/or stable business. The market was so hot and investors became irrationally confident that the Internet would grow indefinitely, causing many to believe that any business operating within the Internet industry would ultimately succeed.

Currently, we find ourselves in a market environment with similar echoes of investor overconfidence. Just recently at the end of May this year, two important indices hit record highs, with the Nasdaq Composite reaching 5,107 on May 27 and the S&P 500 climbing to 2,130.82 on May 21. Even experts are pointing to possible signs of a bubble. Nobel Laureate Robert Shiller says:

"I define a bubble as a social epidemic that involves extravagant expectations for the future. Today, there is certainly a social and psychological phenomenon of people observing past price increases and thinking that they might keep going. So there is a bubble element in what we see. But I'm not sure that the current situation is a classic bubble because I'm not certain that most people have extravagant expectations."

 

All of these signs are pointing toward pricing indicators that serve as good proxies for investor overconfidence and impending market volatility. The real reason behind a bubble is excessive exuberance for a market that might not be able to sustain itself into perpetuity. Currently, there are various market signals of upcoming difficulties that have been largely overlooked.

1. China

For the previous decade China has done a relatively decent job at propping up the global economy. A massive consumer that seemingly has endless deep pockets, China's economy has consumed and grown at breakneck pace. Even today the markets have been lifted with the expectations that the Chinese government will permit its currency to devalue in order to boost growth. Additionally, analysts expect the Chinese central bank to respond with a further easing of monetary policy to push down borrowing costs and the value of the currency. Amidst this year-long slowdown which has brought even more direct government intervention to the fold, the recent slide on the Shanghai stock market alarmed Chinese investors. This was prevented from turning into a larger fiasco only by the involvement of the central bank in imposing stricter trading rules.

2. Commodity and Energy Pricing

Global energy prices have been a recent hot topic of discussion as expectations by China have been heavily tempered over the last six months. The oil pricing mechanism is intricately tied not only to trade and production, but also directly to all other forms and ancillary businesses related to the production and storage of energy. The type of fall and unanticipated volatility could potentially create market shocks that are exacerbated by a U.S.-centric investor optimism environment.

 

3. Greece and the Eurozone

Already falling away from the headlines, we recently witnessed a heavy stress on the European Union caused by Greece's inability to pay its debts. The unrest highlighted not only much of the economic uncertainty and unemployment pervasive throughout Europe, but also the tenacious relationship and strength of the actual European Union. However, while European Union member states utilize the same currency, their sentiments of separation and distinction are very clear. Whether this serves to bolster or weaken the European Union is up for debate, but it is abundantly clear that the Eurozone Crisis has left many questioning the efficacy of a monetary union without joining fiscal policies.

While these are only the biggest topics on the plate today, it points to fundamental underlying issues within the market that could potentially create severe volatility at any given point. With these types of expectations, it becomes even more important that investors have sufficiently diversified their portfolios to be able to withstand potential systematic shocks that seem to occur ever more frequently.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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