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Learning to Spot an Investment Bubble

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Learning how to invest while young is likely the best investment in time you will ever make. You can attempt a variety of strategies on paper. If they succeed, they may be used with real money once you have some to invest. If they do not, you learn a valuable lesson without losing any money.

Today, let us look at ways to practice identifying investment bubbles.  

Choose and Investment to Track

Begin studying the market, market sectors, and individual stocks. Try to find something that is currently and constantly in the daily news (i.e. stocks in the Mania phase of a bubble). Select one or two examples to study.

You might want to consider the following. In 2009 USD returns, XL Capital rose 389%. Ford rose 309%. Google increased 101%. Copper, the commodity, grew almost 140%. Palladium, another commodity, increased 220%. Gold, while only up 25% is trading at nearly 20 year highs.

Are these bubbles, ready to burst? Only time will tell (although I suspect that 4 of the 6 will retreat in 2010). So what can you do to try and identify bubbles in the making.

Look Back to Get Ahead

Where was the market or stock 24, 12, and 6 months ago as far as share price, analyst recommendations, price estimates, new products, competition, general news?

If you do not have a brokerage account, you can obtain significant information from Yahoo Finance, a company’s own web-site or even just performing a Google/Yahoo/Bing search.

If you have a brokerage account, you should be able to obtain even more research on a company.

Where are We Today?

Compared to these prior periods, how much has the stock appreciated?

Which analysts were correct in their forecasts for share price or earnings? Which were the worst? How have the recommendations changed over time? Did other analysts jump on the bandwagon once it became clear that the stock was moving up in price?

At what point did the media pick up on the story? For a bubble, a stock should be first picked up in the financial press (financial newspapers and websites, financial television, etc.). As the mania commences, the stock should start being discussed in main-stream media (New York Times, ABC evening news, etc.). By doing a Google news search, there should be a direct correlation between share price increase and the number of related articles you uncover.

Look at the underlying company (or commodity, market, etc.). Do the fundamentals make sense? You will need to have taken a finance class or two to understand this area. What is the estimated price/earnings ratio? Does it make any sense compared to history, other companies, the market in general? Has the company made a new product or otherwise found a way to increase its sales and profits to justify the increased share price? For commodities, has there been some underlying reason as to why the demand for the commodity is so high? Is the demand expected to continue in the future?

Moving Forward

Keep an eye on the stock, market, sector, or commodity.

Where does the share price end up in 12 or 24 months time? Has it continued to rise or has there been a correction downwards in share price?

If there has been a correction, are there any specific reasons? How fast did the correction take place? The less capitalized the company, the steeper the correction.

Have the analyst recommendations changed? Did any changes in recommendation come in advance of a share decline or were the changes too late to matter?

Learn not just what happened, but why.

Try to identify any subtle triggers that came before a price change. Did the change occur before of after a change in the analysts’ recommendations? Did a front-page news story impact the price? Were insiders buying or selling in advance of a price change?

What did the pundits on the business channels have to say? While my faith in the predictive ability of the financial press is low, they manage to do a great post-mortem analysis as to what has already happened.

And the Cycle Continues

Try the whole process again. However, this time pretend you have invested money into the stock. Follow the steps above and try to determine when you should sell the shares.

Maybe the stock is already in its last stages of price growth or maybe you still have some upward potential.

When you decide to “sell”, be honest with your assessment. On the day you “sell”, assume that you only realized the closing bid price. This is important for thinly traded stocks and stocks that are falling fast. You can only sell if there is a buyer, so if you need to get out, you may be forced to accept a low bid and not something higher.

After you “sell”, continue tracking the stock to see how your timing was.

Do your own post-mortem and learn from any mistakes you made.

By understanding what happened and why, you will be in a better position to identify and act in the future with real money.