What is a stock market bubble?
A stock market bubble is a significant run-up in stock prices without a corresponding increase in the value of the businesses they represent. A company's valuation should be determined by its business fundamentals -- its profits, growth rate, and similar factors. In a bubble, speculation and euphoria take over.
The dot-com bubble of the late 1990s may be the most recent famous example of a stock market bubble. Tech stocks surged, fueled by high expectations for a new internet economy. When those expectations were not realized, almost all of the tech stocks that had gained value during the boom years plunged or the underlying companies went out of business entirely. Arguably, the collapse in high-growth tech stocks from 2021 to early 2022 was also evidence of a bubble.
Not every surge in stock prices is a sign of a bubble, however. Sometimes, large stock gains are justified by the companies' performances. For example, Amazon (AMZN +1.77%) stock has jumped in price by 1,760% in the past decade, but the company's earnings have increased even more during that time, and its competitive advantages have strengthened.
Market Sentiment
Often the clearest sign of a stock market bubble is market sentiment, or how investors feel about the stock market. J.P. Morgan famously sold his stock holdings ahead of the Great Depression after a shoeshine boy asked him how he could buy stocks. Similarly, there were signs on social media platforms during much of the pandemic boom of euphoric sentiment in the market.
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How to protect your portfolio during a stock market bubble
The easiest way to preserve your portfolio's value during the bursting of a stock market bubble is to only hold stocks with strong business fundamentals. In the current environment, Target (TGT +0.91%) and Alphabet (GOOG -0.05%) (GOOGL +0.07%) offer good examples.
Easy come, easy go is the way of portfolio gains during market bubbles. Stock prices that have jumped for little "fundamental" reason can easily lose value if (and when) investor sentiment changes like it did for tech stocks in the late 1990s and pandemic stocks over the past year.
Another way to protect your portfolio during a stock market bubble is to buy put options, which enable you to sell stock at a pre-determined price within a certain time period. You may also use stop-loss orders, which instruct your broker to sell a stock once its price declines to a certain value. The disadvantages of these alternatives are that buying put options can be expensive, and stop-loss orders might be executed during only a modest market pullback rather than a bubble popping entirely. Timing the market, after all, is almost impossible.
The past two years have shown how unpredictable the stock market can be. There's no perfect way to insulate yourself from volatility in the stock market, and bubbles do occur from time to time. The best approach, and one of the easiest, is to buy shares in high-quality companies and hold them for the long term.
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