Asset bubbles in the financial markets are inevitable, and while they can’t easily be forecasted, there are some reliable methods by which investors and traders can detect their presence.

When the price of an asset appreciates rapidly, investors and traders often wonder whether a so-called “bubble” might be developing. That’s probably because most experienced investors and traders have gotten burned by bubbles in the past. 

In the financial world, the term “bubble” refers to dramatic, unsustained rallies in the price of a given asset or group of assets. Bubbles are usually fueled by irrational exuberance—situations in which bullish investors and traders drive up prices well beyond their fundamental value.

The problem with bubbles is that their existence and impact aren’t usually recognized until after the full bubble cycle has completed—meaning most bubbles only look like bubbles with the benefit of hindsight.

One of the first asset bubbles is often attributed to the Dutch Tulip mania of 1637. At the peak of this speculative frenzy, a single tulip bulb sold for more than 10 times the annual income of a skilled artisan.

Today, there are undoubtedly asset bubbles developing within the ongoing “everything rally.” But it may take many months before they are revealed—likely through a dramatic collapse in the price of an asset or multiple assets.

Certainly, many have wondered whether speculative activity might be inflating unsustainable bubbles in the electric vehicle and cryptocurrency sectors.

Interestingly, a couple of the best-known narratives from each of those sectors recently cross-pollinated when Tesla (TSLA) announced it had acquired $1.5 billion worth of bitcoin (/BTC) in early February. Should electric vehicles and/or cryptocurrencies ultimately reach bubble status in historical terms, that transaction will undoubtedly be forever memorialized in the form of countless memes. 

But memes aside, an important question for investors and traders is whether bubbles can be accurately forecasted or predicted. 

At this stage, the answer is unfortunately “no”—at least not in a consistently accurate fashion.

However, research models do exist that can at least alert market participants to the possible formation of bubbles, something investors and traders can use as a potential red flag to strengthen adherence to risk management practices during such periods. 

Effective risk management is always recommended, but its importance grows in stature when bubbles are inflating. That’s because the bursting of an asset bubble can be unpredictable in terms of impact. 

The Beanie Baby bubble, which saw the dramatic rise in the value of a children’s toy during the 1990s, wasn’t obviously that far-reaching when it burst. That’s not to say people didn’t lose money—they did. 

However, the Financial Crisis of 2008-2009 was nearly catastrophic in comparison, and it was catalyzed by the bursting of the global real estate bubble. The collapse in real estate prices ultimately spread over to the stock market and dominoed into one of the sharpest pullbacks in history.

Some of the worst bear markets (defined as a stock market correction of at least 20%) in U.S. history are highlighted in the graphic below, including February/March of 2020. 

So, what data can market participants use to analyze a given asset, or group of assets, to screen for potential bubbles?

According to research conducted by three professors at Harvard University, one of the biggest red flags to watch out for is a rally in an asset (or group of assets) of more than 100% during a two-year period. 

For the purposes of this study, the researchers defined a bubble cycle as a rally of more than 100% during a two-year period, followed by a collapse of at least 40% at some point during the subsequent two years. 

Using that criterion, the Harvard professors uncovered 40 instances (going back to 1928) in which an industry rallied by more than 100% in a two-year period. Of those 40 instances, 21 of the industries experienced a crash of at least 40% in the subsequent two years.

Accordingly to that data, an industry experiencing a 100% rally over a two-year period therefore has a 53% chance (21/40 = 53%) of pulling back at least 40% during the next two years.

While that may not sound like earth-shattering information, consider that most people probably don’t want to risk their life savings on what amounts to essentially a coin toss. 

Interestingly, when looking further at both Tesla and bitcoin, one can see that each of those assets experienced a sharp correction in the last several years after rallying more than 100%. 

Bitcoin famously rallied from a penny per coin to nearly $20,000 before losing 67% of its value in late 2017 and early 2018. Tesla stock behaved in similar fashion when it cratered by nearly 60% at the outset of the coronavirus crisis in February/March 2020. 

Unfortunately, the aforementioned bubble research at Harvard was completed in 2017, meaning the more recent events in Tesla stock and bitcoin hadn’t yet come to pass. Back in 2017, the researchers cited the coal sector as one of the most recent bubbles—rallying and subsequently collapsing from 2006 to 2015, as illustrated below. 

Of course, the ultimate takeaway from this bubble research depends on one’s own unique investing/trading philosophy and market outlook.

However, it’s fairly clear from the data that market participants should be on alert when an asset (or group of assets) rallies by more than 100% during a two-year period. The odds that a rally such as this ends with a sharp correction is just over 50%. 

It should be noted that the researchers also examined historical instances in which a given industry rallied by more than 150% during a two-year window. This research revealed that the likelihood of a 40% correction during the subsequent two years increased from 53% to 80%. 

That data seems to indicate that as the strength of a rally intensifies, so too does the risk of a potential collapse. 

The above research casts recent stock market performance—since the market bottomed last March—in a different light. Since mid-March of last year, the Nasdaq 100 is up more than 95%, the S&P 500 is up more than 70% and the Russell 2000 is up more than 120%.

Moreover, the price of a single bitcoin has appreciated by more than 900%, while the price of a single share of Tesla stock has risen more than 800%.   

The researchers did note that the results of their study were more applicable to specific industries than to the market as a whole—a distinction that might indicate the potential bubbles in Tesla and bitcoin are more relevant to this analysis than broad market indexes.

However, if an industry bubble does burst in the near future, it’s likely such an event would once again spill over into the broader stock market—although to what degree is anyone’s guess.

It’s entirely possible there’s more than one bubble hiding in the “everything rally,” as well. 

For example, one of the best-known solar ETFs, the Invesco Solar ETF (TAN), is up more than 400% since last March. Moreover, the sector ETFs listed below rallied more than 95% during 2020:

• O’Shares Global Internet Giants ETF (OGIG) 97%
• ARK Fintech Innovation ETF (ARKF) 99%
• Global X Lithium & Battery Tech ETF (LIT) 104%
• Amplify Online Retail ETF (IBUY) 115%
• ARK Next Generation Internet ETF (ARKW) 146%
• Invesco WilderHill Clean Energy ETF (PWB) 172%
• ARK Genomic Revolution ETF (ARKG) 184%

For more information about the science and psychology behind financial bubbles, readers are encouraged to review a new episode of The Skinny on Quantitative Finance on the tastytrade financial network. 

To follow everything moving the markets on a daily basis, readers may also want to tune into TASTYTRADE LIVE, weekdays from 7 a.m. to 4 p.m. Central Time. 

Subscribe to Luckbox in print and get a FREE Luckbox T-shirt! See SUBSCRIBE or UPGRADE TO PRINT (upper right) for more info.

Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to support@luckboxmagazine.com.