Price Bubbles

Recognizing a price bubble as it occurs is difficult because the bubble forms over a long enough period that many investors accept higher and higher prices as the norm and not the exception. Therefore, they often ignore the extraordinary valuations and continue to buy believing prices will move up forever.

To spot a bubble in the making apply the following graphically techniques. We used S&P data for the analysis.

S&P 500 Price Bubble

The price chart shows the 1982 to 2000 bull market end with the bubble bursting and prices falling dramatically.

Look for a Change in the Long-term Tendline

The dark green long-term trendline of increasing prices is evident. But notice starting in 1994 a shorter-term steep up trendline developed indicating a well-defined deviation from the long-term price tendline.

Look for a Spike in the Ratio of S&P 500 to DJIA

The up move and spike in the ratio of the S&P 500 to DJIA prices indicates the S&P 500 relative to the DJIA was becoming overvalued. The spike was caused by the run up in prices of the technology stocks included in the S&P 500 but not included in the DJIA.

The Nasdaq to DJIA ratio is more dramatic.

Look for a Spike in the Price-to-Earnings Ratio

This very long-term chart from 1861 to 2001 of S&P price-to-earnings ratios, based on data from Robert Shiller, shows an all-time peak of p/e in 2000. In 1929 p/e peaked before prices collapsed in the 1929 crash.

Look for a Low in the Dividend Yield

As prices increase very rapidly, the dividend yield (dividend/price) decreases. Therefore, very low dividends yields are associated with very high prices. Historically most SP dividend yields have been between 4% and 5%. So the 1.2% dividend yield at the market peak in 2000 was very low compared with historical yields. Also a slowdown in dividends paid in the 1990s contributed to the low yield.