The Danger Of Stock Market Bubbles & How To Steer Clear Of Them

Bubbles...they're enticing. They suck people in. The price action seems to validate their feelings and even the media hype, I mean "stories" that come in seem to further validate their emotional purchase.

On top of this, bubbles fuel human greed, the get-rich-quick itch that people have that they want to scratch. They want to believe in the story so bad. So when the media and the price action seems to justify their "emotional high" and "greed", they buy shares...and not just some shares, they usually "bet the farm" on these stocks because in their mind, "they're a sure thing" and if some shares would be good then a lot of shares is better and could make them rich.

Okay, so how do you keep from getting sucked into bubbles like bitcoin and Boeing are presently in? Well, let's take a look at a former bubble that's already gone through the whole process and I'll walk you through things to be aware of, so that you too don't get sucked into the vortex along with many of the masses.

Remember the 3D printing mania. It was going to change the world. There was going to be one in every home and people would order stuff from Amazon and other places and it would just be created right in front of them?

You see, with every bubble, there's a bit of truth mixed with the story being taken WAY too far. Hey, some day, something like that may be a reality. But it was too much, too soon. Okay, with that in mind, let's look to the chart of 3D Systems (DDD), the poster child for 3D printing.

Those of you who've followed me for any length of time know that I talk about how there are five waves (1-2-3-4-5, which are really five phases of sentiment) to an uptrend and three waves (phases) of sentiment in a downtrend (a-b-c).

In waves 1 and 2, early adopters have piled in and large investment funds that can spread their money around many speculative bets. After all, if only one or two of their many bets pays off, it helps to compensate for the others that never flourish at all.

In these phases, the media is not onto the scent yet and the retail public is not really aware nor do they care. However, once wave 3 gets well under way, the media stories are flooding the airwaves and the public is very aware. Investors who aren't savvy begin to pile into an overpriced/overvalued asset because of being sold a bill of goods of the promise of what the company is going to do one day.

By the time wave 5 comes around, people are giddy about the stock. Moms and pops are bragging around the water coolers at work about how much money they're making and how they're such a genius for spotting this diamond. You couldn't talk these people out of their shares for anything at this point because they've already seen such a steep rise and their greed just won't let them turn loose of the shares because of the fear of being "left behind". They feel it will be their "ticket to riches" and they can tell their boss where to stick it as they kick back and buy a yacht and cruise the open waters.

And...it's about that time that the stock begins to crash. However, you still can't convince them at this point that the downtrend has happened and the top has come. Why? When would the moms and pops of the world ever realize when a top is happening? So they're always going to ride it up and ride it down.

But the first pullback (wave a) just seems like a dip that ought to be bought. Also, late adopters feel its their last chance to get in on it before it makes its next huge run-up. However, it ends up just being a "bear market bounce" (wave b) and the downtrend continues.

Notice the uptrend took this stock from $1.25 up to $97 and then back down to $6 before it was all said and done.

Most people would have gotten in on it part of the way through wave 3 up to wave 5. Towards the end of wave 5 there would likely be the most retail investor participation because it's at the height of investor optimism. So that means they would have likely bought in between $60-$97 only to finally sell when the huge, red volume spikes occur around the $6-$19 region. (Sure, there's one massive sell spike near its top but almost 70 million shares sold in a week are huge institutions exiting, not moms and pops. At that point, moms and pops only see it as a dip that will only return to an even "higher high").

How would the institutions know to exit? It's what I want to teach you today so that you too can avoid these bubbles and their downdrafts.

The institutions know its a wave of momentum that they're riding because its not based on present earnings and the P/E's are so "through the roof" that they're clearly unjustifiable. So they're looking for the danger signs to exit. What are those danger signs?

The first, and most obvious is the parabolic/steep move on the weekly chart. Anything that goes up that steep/fast is a bubble and it will pop likely as hard as it went up. They tend to end up looking like an upside down "V" formation.

Secondly, large institutions know that when the price gets a crazy distance from the 50- and especially the 200-week moving average that the dangers are HIGH. It's why they start selling out on the rallies higher. Notice the selling spikes began to increase from early-2013 through the beginning of the crash in early-2014.

By the time the top comes, these large institutions have trimmed their positions significantly and so they're exiting their final shares near the top. If they miss that chance, they fully exit on the bounce higher of wave b.

Sure, they don't know "exactly" when the top has arrived, but they know when they're getting close by how hyped the media reports get, by the RSI divergence, by how far stretched above the 200-week moving average the price has gotten, etc. And sure, even some institutions will get sucked into the vortex as well. But of the ones that don't get sucked into the hype...they're able to avoid it and keep their wits about them because they only look to things which are measurable, such as Elliott Wave counts/phases, watching the parabolic move away from the 200-week moving average, divergences, selling volume intensity, etc. And these are the same things that you can learn to look to as well.

If you ever lose sight of that (and you'll be compelled to)...then you'll go from being a Logical Investor to being what the masses are...illogical/emotionally-led investors (which are not truly investors at all).

In fact, you'll see the truest of investors (Warren Buffett, Jim Rogers, etc.) totally avoid these bubbles altogether. Remember when Buffett was ridiculed in the tech bubble because he didn't own any tech stocks? Yet, he didn't experience their crashes either and he's still around today when many of the "tech investors" around 2000 are no longer around.

In the heat of the moment, these investors seem to look "out of touch" and in denial. They seem like they're "has been" investors that are now "washed up". They're disrespected by the ones riding the bubble. But when it's all said and done, you see the wisdom that kept them solvent and still around to take advantage of future bonafide rallies of real companies with actual earnings (presently, not a future promise of earnings) with realistic price-to-earnings ratios and plenty of cash on their books with low debts, etc. These are the ones that avoid bubbles and make it the long haul in investing while the other hype-junkies fall by the wayside.

I hope this has blessed you today and armed you with information that can help you avoid some of the most common investor pitfalls. God bless you!

Here's bitcoin's 4-year chart. The parabolic move/bubble can easily be seen.

Here's Boeing over the last 10 years. The stock has doubled in about a year and nine months. The price is very far away from its 200-week moving average.

Excellent article Sean! I used it to get out of a position which was beginning to go parabolic. It's P/E is 47.