What Happens if the Stock Market Bubble Bursts?

It has been a bad week for the stock market and the Dow is down -4.7% since Tuesday. This generates a lot of fear that the market may be changing to a downward direction. In order to not get caught up in the fear, it is helpful to take a step back and look at the big picture of what is going on. This will help you when you are making financial decisions. So in this video I am going to be answering the question, what happens if the stock market bubble pops. WATCH NOW!

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VIDEO SUMMARY

Let us take a very big picture view to start. You can divide the market into two main groups of investors: bulls and bears. People who are bullish on the market, think the market is going to increase, and make investing decisions based on that theory. People who are bearish, think the market is going to decrease, and make more defensive investing decisions.

Finance is about mitigating risk. You want to understand both perspectives at any moment in time. Even if you think the market is going to increase, you still want to understand what bearish investors are thinking, so you can prepare against potential downside risks.

What are people saying right now from both perspectives? Bullish investors are talking about how the economy is reopening. As the economy gets stronger, it will push stock prices higher.

Bearish investors are saying something quite different. Bearish investors are saying that we are currently in a stock market bubble. When that bubble pops, it is going to create an enormous amount of pain.

I do not make predictions on this channel. I am not saying that we are in a bubble or not in a bubble. You can make up your own mind. But I do think it is helpful to walk through these scenarios. Then no matter what happens, you can be more prepared to protect yourself against those risks.

Let me start by addressing two myths about the stock market.

Myth 1: The stock market will increase forever. FALSE. There are a lot of examples throughout history of financial markets that crash and never recover again… ever. Prices are never guaranteed to go up, and you need to recognize that as a potential possibility. At the very least, there is a scenario of a crash, and a recovery period that exceeds 30 years. 30 years is a long enough period of time, where it might as well have not recovered at all, because you still would have never recovered your earnings by the time you have to retire.

Myth 2: There will always be demand to invest in stocks. FALSE. A stock is just a product you can buy. But in the investment world, there are lots of different alternatives. People do not have to invest in stocks at all. People can invest in real estate. People can invest in bonds. People can invest in private businesses. People can invest in their own education. So if people start thinking that the stock market is not likely to generate a return, they are going to start looking at other places to put their money.

Just one example I think might happen, people might start buying more real estate outside of the United States. Because if you have a bunch of money to invest, and you are looking for alternatives to the stock market, foreign real estate not only gives you an asset that can appreciate, it provides your family with more flexibility on places to live. The point is that people do not have to invest in the stock market to get a return on their money.

When we start to look at these myths, you realize there is a lot of risk to investing in the stock market to begin with. Let’s now look at the additional reasons people currently think we are in a bubble.

1. The market is acting irrationally. Since the crash in March, the Dow is up 35%, at the same time the global economy is a disaster. The Dow actually broke above the pre-COVID-19 levels. Just think about that. People are paying the same price for stocks, when the economy is so much worse. If the market keeps growing at this rate, you will more than double your money in a year. This has created a lot of confusion. How can the stock market be so great, while the economy is so bad. At the very least, this should raise concerns that something strange is going on in financial markets.
2. Prices are being driven by speculation rather than dividends. These are the two factors that drive stock price. Stock is an ownership percentage in a company. For some companies you receive a percentage of profits each quarter in a dividend. You can determine the present value of cash flows you expect to receive from owning the stock, and then determine an acceptable price. That is called investing based on fundamentals. However, you can also make money through the stock appreciating in value and selling it for a profit. Changes in price are based on supply and demand for the stock. That is based on speculation. If speculation is driving prices, as opposed to fundamentals, it becomes more risky, because supply and demand for stocks can change, and prices can drop. We can measure this by looking at stock price compared to company earnings (or price-to-earnings ratio).

This is a great chart from LongTermTrends.net that show S&P 500 PE ratios since the 50s. The green line shows prices in what would historically be considered fair value. We see that during recessions, like the dot com bubble and the housing crash, that the PE ratio tends to increase as company earnings drop.

3. Aggressive Federal Reserve actions are unprecedented. The Fed is funding liquidity. This means that if a company is struggling to issue debt, the Fed will come in and make sure they can get debt. Even bad companies, that no banks want to lend to, will be able to get debt. This essentially means that no companies should be going bankrupt, because even if they have no revenue, the Fed will make sure they can get debt to pay their bills.

This removes all the downside risk from owning stocks. Normally, if a company goes bankrupt, you lose all the value of the stock. But if no companies can go bankrupt, the Fed has removed the risk of owning stocks.

In this scenario, two things can happen. The Fed is going to roll back these liquidity measures eventually, which will create downward pressure on stock prices, as companies go bankrupt. Or stock holders will realize their stocks are not worth as much as they thought and start a sell-off. Once a sell-off starts, there is no way to stop it, because no one wants to be the last person to sell their stocks.

There is a fundamental issue here. The Fed has increased liquidity to avoid a financial crisis. This has removed risk from the stock market. The Dow has increased 35% in one quarter. You would make more money sitting at home and investing in the stock market, then you would make by going out and getting a job. There is a disincentive for people to go out and work, and work is what the US needs to get out of this financial crisis. Financial markets do not work without appropriate risk profiles, which means banks should not be lending to companies that don’t deserve it, and people should not buy stocks without pricing in the possibility of losing all their money from a company bankruptcy.

Now I want to hear from you. We have talked about two scenarios: a bullish scenario and a bearish scenario. What do you think is going to happen? Leave a comment down below. I love reading your comments because I always get comments from both perspectives and it is always a great read. So leave your comment below on what you think. Stay safe out there everybody. I’m Zach from Wolves and Finance. Let’s go out and make some money.

Leave a comment down below letting me know what you think!

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Neither Zach De Gregorio or Wolves and Finance shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.