Signs point to an imminent stock market crash – how can you protect your investments?

Although there are multiple definitions of what a ‘bubble’ is, the essence of them all is that stock prices have gotten to an unsustainably high level, driven by unreasonably positive investor expectations – and when those expectations change, prices will revert to normal, dropping a lot in the process.

After a record rebound from a pandemic-induced market crash last March, stock benchmarks worldwide have raced past a series of record highs in the early days of 2021. As stocks hit record highs, top banks are getting an increasing number of inquiries on whether the boom, which has some parallels to the dotcom crash, will result in a similar bust.

“We are receiving numerous questions (on) whether a bubble is potentially forming in financial markets,” Mislav Matejka, head of global equity strategy at global lending giant JPMorgan, wrote in a note recently.

Is a market bubble forming?

Let’s first answer this: Are stock prices truly at what experts define an ‘insanely high’ level?

More research and analysis show almost every price-based indicator indicating it is. Whether you look at sales, book value, earnings, or any price-based metric at all, stocks are not only incredibly expensive but close to as expensive as they have ever been.

The stock market has soared at the start of 2021 despite some investors worrying we'd see declines early on in the year – however, the question remains: How long can this rally keep going?

Given the way stocks on the whole are extremely overvalued right now, trend watchers say it's pretty much inevitable that at some point, the current bubble is going to burst. It may happen in February, March, or even beyond, but current trading levels really aren't sustainable.

Signs of an imminent market tumble

A stock-market bubble typically starts when investors fall in love with some new development and possibility, leading investors to pour money into stocks as prices rapidly increase. This often becomes euphoria, with caution thrown to the wind.

Bubble markets also often display bizarre behavior right before they tumble. While several analysts are currently of the opinion that investors are under the misplaced notion that risk in markets has vanished, there are other industry experts who hold an opposing view.

The current stock market rally is compared to the more abrupt rise and fall of dotcom stocks in the late 1990s and the extended rise and fall in commodities’ stocks in the opening decade of the 2000s. Also, Google search trends for “stock market bubble” are at their highest since 2004.

What changed this week?

Global stocks came under pressure in recent days as millions of small investors united to drive up the share prices of an unprofitable US-based video-game store chain stock GameStop and other stocks such as cinema chain AMC, pocketing money from top hedge funds that were betting on the stocks to fall.

With GameStop shares soaring 1,700 per cent and AMC up around 470 per cent since the start of the year, losses for hedge funds and other short-sellers catapulted to around $19 billion (Dh70 billion) in the year so far.

Moreover, the US Securities and Exchange Commission (SEC) came under fire and warned Thursday that "extreme stock price volatility" has the potential to cause "rapid and severe losses" for investors and to undermine market confidence.

Concerns of market ‘bubble’ spike

This is why analysts are now of the opinion that unwarranted rises in stock prices are fuelling concerns that markets are currently in a bubble state amid mounting evidence of extreme ‘market speculation’ - in light of unreasonable price surges of assets like Bitcoin and others unprofitable stocks.

Analysts note the world’s largest cryptocurrency Bitcoin, which rose 400 per cent last year, continues to prove its extremely volatile nature after surging 20 per cent early on Friday after Tesla boss Elon Musk added the hashtag #bitcoin to his Twitter bio.

Robert Shiller, a Nobel Prize-winning economist and a recognised expert on market bubbles, opined recently how the social media-fuelled stock speculation and price surge is being driven by not just historically low interest rates, but by social trends as well.

How to protect your investments in a market bubble

1. Get rid of risky investments first

While some follow general sentiment and sell investments, smart investors start by selling risky investment positions, like those stocks with a history of volatility, and those with new business models.

Instead of selling everything, top investors just sell the risky investments in their portfolios while holding onto stable investments in firmly established companies, such as blue-chip companies.

2. Shop for fixed-income investments

Investors often move their funds into fixed-income investments when the markets look unstable. Fixed-income investments mostly include bonds.

Bond prices tend to move inversely to the stock market, so when stock prices fall, bond prices rise. In the event of a large market downturn, bond prices may fall along with stocks, although their yields should increase in turn.

3. Tweak how you allocate money to your assets

Asset allocation refers to how your investments are divided within your portfolio. When you're young and have many years before you retire, you can afford to allocate a larger portion of your portfolio to stocks. The logic is that even if the market crashes, your investments have plenty of time to bounce back.

However, if you're closer to retirement age, check if you're investing too aggressively. If the majority of your portfolio is allocated toward stocks and the market sinks, you won't have much time to wait for prices to recover before you retire and begin to sell assets to help cover your expenses.

To get a rough estimate, subtract your age from 110. The result is the percentage of your portfolio that should be invested in stocks. The rest should be invested in bonds or other relatively conservative assets. So let’s say you're 65, you may choose to invest around 45 per cent of your portfolio in stocks and 55 per cent in bonds.

4. Stash more money towards your emergency fund

While it’s always recommended to have sufficient money in an emergency fund, it's especially useful when the stock market is heading downward.

If your emergency fund is too small, you may have no choice but to withdraw from your savings and if you plan on liquidating your assets during a market downturn, you're selling when prices are low.

So if you have cash to spare right now, put it into your emergency fund instead.