How to detect stock market bubble?
When it comes to investing for greater returns for ten years down the road, dollar cost averaging every single month of the year regardless of the prices of the stock market is not a very wise choice, especially since prices of equities always swings like a pendulum. While we all cannot determine the top and the bottom, we can at least know where the general top and bottom areas lie.
Be it enter the stock market through direct stock ownerships, actively managed mutual funds or passively managed index funds, it will be wise to at least know how to detect the prices are in the regions of bubbles and to stay away from it until the bubble completely burst. The following analysis can be used in conjunction with simple technical analysis like if the price now is near previous highs within the previous 5 years, then it is considered too high.
The real wealth of humanity eventually comes from annual supplies of human labor, both physical and mental. Real wealth that you can live on is cars, houses, food, health care and other consumables that can be consume. All of these things can only be produced by humans in the course of their employments.
Given that most of what we earn, i.e. income, net of spending and savings, will mostly be invested in equities or physical properties, the difference in value between GDP and market capitalization of all the companies listed in stock exchanges of that countries will be a reasonable and reliable estimate of assets bubbles or undervalued assets.
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GDP means gross domestic product of a country, the definition of which is the sum of all goods and services produced in that country. It simply represents the real wealth of the real economy. Market capitalizations of all the companies listed on stock exchanges does not really mean the true wealth, as in if all the people cashed out all their holdings in stocks, there will be many dollars chasing too few goods, eventually causing inflation.
For example, by comparing the increase in GDP of United States from 1980 to 2001, GDP increases by only 281% but the stock market prices from Dow Jones Industrial Average, S&P 500 and NASDAQ increase from between 916% to 1400%, which clearly is some unreal or illusionary wealth. As you can see, eventually, buying at a high price is very risky, as a whole and in the foreseeable future; people just cannot buy stocks at high prices without real economic growth in GDP. There is a crash shortly after 2001, though it is due to dot com bubble.
One way I use to detect stock market bubble is to compare GDP numbers with sum of all the listed companies market capitalizations, this is important if your participation in equities investments is through a diversified holdings of stocks, either mutual funds, index funds or you are rich and hold the diversified portfolios of stocks directly. You want to avoid entering a market when there is clearly a bubble.
One may ask how to compare the figures in this case?
The answer is by simply using a simple formula, the difference between GDP for a given year and sum of all market capitalization during a bear year and that for a bull year.
From the two figures, one can see that the smaller the difference, the safer it is to enter the market.
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