The biggest risk in a bubble? Getting out too early

With record highs every day and extreme valuations, Wall Street's race forward inevitably raises the question of a bubble. But what history teaches us is that one of the main risks for investors is selling too early and thus missing out on a large part of the rally.

In a recent note, the Bank of America team listed all the bubbles since 1900. They counted 14: from the Dow Jones in the late 1920s to Cathie Wood's ARKK fund stocks and Japanese equities in the late 1980s. During these periods, the average increase was 244%... followed by an average decline of 62%.

The bubble of the Magnificent Seven?

Judging by the growth of the US markets over the last few quarters, one might wonder if we are not in a bubble now.

The market and valuation levels reached are mainly due to a few stocks - the Magnificent Seven - whose growth and margin levels may justify paying such high prices for them.

The big question is whether the huge capital expenditures deployed to develop AI infrastructure will generate a sufficient return on investment. In short, capital expenditures by the four hyperscalers (Alphabet, Meta, Microsoft, Amazon) are expected to total $361bn in fiscal year 2025 alone.

It is still too early to know whether these investments will pay off or not. And only the answer to this question will tell us whether or not we are in a bubble.

The exuberance may last

Let's assume that we are in a bubble and that in a few years' time, everyone will add a fifteenth bubble to the Bank of America list without blinking an eye.

The next question is: at what stage of the bubble are we? Because periods of exuberance can last much longer than expected. And in that case, exiting prematurely means missing out on tens or even hundreds of percent.

Let's take the internet bubble of the 1990s as an example, since parallels with this period are often drawn. The Nasdaq 100 rose from 572 points at the beginning of 1996 to 1,903 points at the beginning of 1999, an increase of over 200%. But between 1999 and the peak in March 2000, the index more than doubled again.

Source: MarketScreener

However, for managers who compare themselves to the indices all day long, it may be more painful to miss out on the rise than to face a correction that everyone is experiencing.

This brings us back to one of the main psychological biases in financial markets: FOMO (fear of missing out). A fear of missing the upward trend, which can itself fuel the rise.