When the prices of an asset, such as a stock, soar to exorbitant levels, it may be a sign of market froth. Froth occurs when investor demand drives asset prices above their intrinsic values, often creating a market bubble. When a bubble bursts, prices crash.
Let’s explore the basics of market frothiness and how to tell when we’re in a frothy market. We’ll discuss some historical examples of froth, such as the dot-com bubble and the period leading up to the 2008 housing crash. We’ll also cover what to do if you’re worried that a market bubble is about to burst.
Definition and Examples of Froth
Froth is generally the period in which demand drives up an asset price to unsustainably high levels. Often, froth creates the conditions for a market bubble. Investors worry about a market bubble because if the bubble bursts, prices will drop rapidly.
Federal Reserve Chairman Alan Greenspan testified in 2005 that there were “signs of froth in some local markets where home prices seem to have risen to unsustainable levels.” At the time, however, Greenspan doubted there was a nationwide housing bubble. He expressed concern about interest-only loans and adjustable-rate mortgages driving households to buy homes they couldn’t otherwise afford.
After peaking in July 2006, housing values began to decline. The S&P/Case-Shiller U.S. National Home Price Index went on to record 32 months of consecutive declines. Many of the risky loans made during the period of market frothiness went into default. These loans were often packaged into mortgage-backed securities, creating hundreds of billions of dollars in losses. The housing bubble triggered the massive financial crisis that ensued in fall 2008.
Another example of a frothy market is the period before the dot-com bubble burst in 2000. In the mid-1990s, investors poured money into tech businesses, including internet startup companies like the ill-fated Pets.com. The tech-heavy Nasdaq index reached a high of 5,048.62 on March 10, 2000, and then it began to tumble. The index lost more than 75% of its value during the next two and a half years and didn’t surpass its March 2000 record until April 23, 2015.
How Market Froth Works
Froth occurs when an asset’s value becomes inflated. A frothy market often creates a bubble that eventually bursts. But increasing prices alone don’t indicate market frothiness or an asset bubble.
The distinguishing characteristic of froth is that asset prices rise at a rate that isn’t justified by fundamentals. As a result, these price increases aren’t sustainable over time. The run-up in prices is often driven by what Greenspan described as “irrational exuberance.”
Common signs of froth within a market include easy access to money and investor confidence that a certain trend—like soaring tech stocks in the 1990s or home prices in the early 2000s—is the new norm. If prices then drop and access to money then tightens, prices will likely sink even further.
The Cyclically Adjusted Price-to-Earnings (CAPE) ratio is a stock’s price divided by its 10-year inflation-adjusted earnings. Some investors apply this formula to a stock index, like the S&P 500, in an attempt to predict stock market bubbles. While historically it has provided accurate information, some researchers have lately critiqued it for being “overly pessimistic.”
What It Means for Individual Investors
While a drop in asset prices can seem scary for investors, if you have a long investment horizon, you don’t need to worry about short-term declines.
In general, investing for the long haul has benefits. For example, research suggests that a 20-year investment in the S&P 500 index anytime between 1919 and 2020 has always produced positive returns.
During periods of market volatility, it may be tempting to sell your investments to cut your losses. However, it is recommended that retail investors prepare their portfolios and ride out the turbulence in the markets.
Researchers have found that a disproportionately large number of U.S. investors engage in panic selling—that is, selling risky assets during sharp downturns. While doing so saves them from short-term losses, it also makes them miss out on long-term gains once markets rebound.
However, if you’re worried about signs of froth, there are a few steps you can take as an individual investor to protect your finances.
A diversified portfolio can protect you from the pop of market bubbles. Maintaining a mix of stocks and bonds is essential. You can also diversify within your stock portfolio by investing in different stock market sectors, stocks with a range of market capitalizations, and a mix of growth and value stocks.
Some investors seek to profit off of market bubbles. They may plan to sell off before the asset starts to tank, or they may attempt to make money from the decline by shorting stocks.
Short selling is particularly risky because there’s theoretically no limit to how much you can lose.
Also, it’s tricky to time the market to figure when is the best time to sell just before the market drops. So market timing and short selling are both risky moves.
You may hear market commentary about froth and bubbles, but they’re usually unpredictable. No one can know for sure when froth can turn into an asset bubble or when that asset bubble will burst.
- Market froth occurs when an asset’s value becomes overinflated. Froth often leads to a bubble.
- Rising prices alone aren’t an indicator of froth. However, prices increasing at a pace that isn’t justified by fundamentals is a sign of market frothiness.
- The periods leading up to the 2000 dot-com bubble crash and the 2008 financial collapse are examples of froth that eventually turned into asset bubbles.