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I see three warning signs of a stock market bubble set to burst!

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In nearly 34 years as an investor, I’ve seen plenty of crazy behaviour. In October 1987, I witnessed the US S&P 500 index collapse by a fifth in one day. During the dotcom boom, I saw shares of (in my view) worthless companies soar tenfold. By 2002, most had crashed to zero. In the global financial crisis of 2007–09, I observed banks collapsing or getting taxpayer bailouts. This year, I saw the FTSE 100 index crash by 35% in the spring and then rebound in the summer. These experiences, amassed over a third of a century, are warning me that a stock market bubble is forcefully inflating today.

Warning sign #1 of a stock market bubble

First, there is a clear and obvious stock market bubble in the shares of electric vehicle (EV) manufacturers and suppliers. The world must transition to a low-carbon future by abandoning fossil-fuelled travel. Yet the current valuations of EV firms and battery makers are ludicrous. The poster child for this investor mania is Elon Musk’s Tesla. Tesla stock is up more than 840% in 12 months. With a current market cap of $616bn, Tesla will enter the S&P 500 on 21 December. Yet this values Tesla at almost $1.25m per car sold. That is, quite frankly, an insane overvaluation. Tesla is a barely profitable bit player in a huge global market. When its stock price implodes, investors will lose the hundreds of billions they made from 2020’s momentum-driven speculation.

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The second signal of bubble trouble

My second sign of a stock market bubble is in US growth stocks, notably the elevated share prices of American tech firms. Many of the mega-techs trade on price-to-earnings ratios above 50 (which equates to a measly earnings yield of 2% a year). That bakes a lot of future earnings growth into current stock prices. Even worse, some newer entrants trade on high multiples of their annual revenues (because their earnings are negative). This disturbs me, because all these ‘next tech’ businesses seem to do is scale up losses as they grow. Every recent tech flotation has seen first-day prices soar, yet there can only be a few winners among these competitors. How can they all be worth 10 to 200 times their modest sales? Some shareholders will get their fingers burned.

More bubble struggles

My third warning of a stock market bubble is the huge disconnect in the US between Wall Street optimism and Main Street reality. Although there is no direct causal link between GDP (gross domestic product) and stock prices, recessions generally drive share prices down. For example, the mother of modern crashes came between 2007 and 2009, when the US housing market collapsed, causing economic insecurity and huge job losses. In 2020, US GDP may decline by as much as 4%, but the S&P 500 is up by almost a fifth in the past year. If 2021 turns out to be anything other than perfect in economic terms, bubble stocks will surely suffer.

What will I do next?

I’m not going to sell everything and head for a log cabin to shelter from the coming storm. What I plan to do in 2021 is to reduce my family’s exposure to highly rated growth shares, particularly in the US. I aim to rebalance our portfolio into lowly rated value stocks, especially the cheap shares lurking in the FTSE 100. But, given the lack of income on offer from bonds, gold, and Bitcoin, we shall stick with stocks for now.

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Cliffdarcy has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Tesla. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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