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Are stocks in a bubble? Why experts say you don't need to worry about signs of 'irrational exuberance' in the market

"It's hard to be in a bubble if everyone thinks nothing but, 'We're in a bubble.'"

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While the market mania that saw stocks such as GameStop and AMC Entertainment shoot through the roof last week appears to have mostly subsided, market experts are still questioning whether the trading frenzy was a self-contained, one-off event or a symptom of a broader, concerning trend.

Some experts say that the investor excitement that led to "meme stocks" flying off the shelves could be a sign of a growing bubble in the broad stock market. Should that bubble burst, the resulting fall in stock prices could have a negative impact on your portfolio.

Here's what experts think about whether the meme-stock mania bubble indicates the stock market in general is a bubble, and why long-term investors don't particularly need to worry.

Stock market bubbles and their impact

In a 1996 speech, then-Fed chairman Alan Greenspan used the phrase "irrational exuberance" to describe collective investor jubilation that drives stock prices higher than their underlying fundamentals can justify. In 2000, at the height of the dot-com boom, market luminary Robert Shiller used the term as a title for his book on economic bubbles.

"The phrase came to define what we think about as a speculative bubble," says Kristina Hooper, chief global market strategist at Invesco. "Irrational exuberance can be applied to the entire market, but when we're talking about bubbles, it's usually a particular asset class or sub-asset class. Bubbles can impact broader indices, but they tend to be centralized."

When tech stocks tanked in 2000 and when the housing bubble burst in 2007, stocks went into bear markets. The plummet in share prices of Reddit-fueled stocks wasn't enough to bring down stocks in other areas of the market, though.

In fact, as prices of so-called "meme stocks" declined, investor worries over speculative trading ebbed this week, and the broad stock market rebounded.

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How stock market bubbles work

Investors looking to understand how bubbles work, Hooper says, should examine the trajectory of the Reddit-led stocks through the framework of the 5 stages of a bubble outlined by Charles Kindleberger in his book "Manias, Panics, and Crashes."

  1. Displacement: Investors get excited about a paradigm shift in the market, such as a new, disruptive technology. The realization among Redditors that they could collectively force a short squeeze in heavily shorted stocks fits the bill, Hooper says.
  2. Boom: Prices begin to rise and then gain momentum. The media typically starts covering the move.
  3. Euphoria: Prices begin to skyrocket and you see participation from a broad group of investors. Or as Shiller puts it in his book, a "larger and larger class of investors who, despite doubts about the real value of an investment, are drawn to it partly by envy of others' successes and partly through a gamblers' excitement." Sound familiar?
  4. Crisis: The insiders who were leading the charge begin to dump the stock. In 2000, for instance, major tech players began to dump shares while retail investors were still piling into vastly overvalued companies.
  5. Revulsion: The bubble bursts, prices begin to fall rapidly, and investors and traders alike look to sell at any price. While GameStop stock hasn't fallen all the way through the basement, its $60 share price as of Monday morning is far below the nearly $350 shares were fetching when the market closed on January 27.

Why some experts are concerned about the broad stock market

While the Reddit bubble may have come and gone, some experts think that the symptoms that caused it remain. Last week's activity was just the latest evidence of rapid growth in market participation from retail investors, perhaps a sign that investors are overly bullish on stocks.

"Just look at your TV," says Sam Stovall, chief investment strategist at investment research firm CFRA. "There are a variety of ads in which people are promoting websites for trading. Sites are popping up like morel mushrooms. That, I think, is a sign."

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Some market-watchers who were around for the 2000 dot-com crash are having déjà vu. "Similarities to 2000 extend beyond heavy retail participation," Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Securities, wrote in a recent note.

Other resemblances that could set off alarm bells for investors, she says: stock market valuations at nosebleed levels, and a large number of stocks gaining no traction among investors despite posting better-than-expected earnings — a sign that investors are keen to speculate rather than pay attention to fundamentals.

Why long-term investors probably don't need to worry

Not everyone buys the idea that the stock market may be a bubble, in part because the concern is so well-reported. "I sure see a lot of stories about bubbles," says Jim Paulsen, chief investment strategist at The Leuthold Group. "It's hard to be in a bubble if everyone thinks nothing but, 'We're in a bubble.' To me, mindsets out there are much more concerned about collapse than about missing out."

Paulsen acknowledges investors looking through to the other side of the pandemic have bid up stock prices, but he doesn't think there will be real exuberance in the market until widespread immunization is truly in sight. Nevertheless, he and nearly every other expert expect there to be a pullback over the next year or two. "There's a huge probability that we're going to get a nasty correction at some point," he says.

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But here's the thing: That is fine, even expected. Those kinds of downdrafts in the stock market are a normal part of doing business. "You have to realize that the market goes through a pullback of 5% to 10% about once every 9 months, on average," says Stovall. "There's always a possibility that we can fall into a pothole. Then the question is, what do I do about it? Your best bet is probably ignoring it."

If you're concerned about a sharp decline in stock prices, make sure your portfolio is aligned with your tolerance for risk, and that you're broadly diversified. Beyond that, your best move is to stay the course, says Hooper.

"We can see bubbles in small parts of the market across the investing universe," she says. "That shouldn't deter people from being diversified, staying invested, and having a long-term approach."

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