Trading Index bubbles in 2023

By Paul Reid

04 January 2023

Financial analysts are forecasting index bubbles in 2023. The popular index bubble theory outlines how an index gets overbought over the long term until buyer momentum runs dry. When the rise peaks, investors start selling, take their profit, and move on to other things.

In the financial market, similar actions occur daily, weekly, and monthly, each overlapping. But, a bubble typically represents a time period of years, a much longer bullish run, and a much bigger fall. The kind of fall that stands out on a five-year chart.

Economic bubbles are not a novel theory and are likely known to all traders with 5+ years of experience analyzing the markets. More so recently, since world media likes to focus on doom and gloom.

Even when bubbles don’t appear, the media tend to play the “bubble burst” card every year these days, waiting for the year when they finally get it right and “called it” first. The added attention means market sentiment will be extra sensitive to bubble talk throughout 2023. Fear of volatility can be the cause of volatility, but, according to the professionals,  there’s something else fueling bubbles and the bursts.

Passive investment causes bubbles

Bubbles most definitely exist, and the causes of them are known, but not spoken about. One such influence is passive investing. Passive investing is typically referring to a long-term strategy targeting an index rather than an individual stock.

Passive investing in an index is believed to be lower risk due to diversification. The investments go across multiple asset classes and industries, specifically the most successful companies in the world. It sounds bulletproof, right? How could it do anything but rise?

No wonder so many investors choose to passively invest in indices. And when we look at the S&P chart for the last 3+ decades, anyone who bought S&P500 and held it over the long term got exactly what they expected.

Over its history, the S&P500 has experienced 50 drawdowns in total, but averaged an annual return of 12%. In other words, over the last 30+ years, no matter when traders bought the S&P500, there was always a profitable exit opportunity for those who waited long enough.

But this trend for buying and holding is a problem. Experts such as Michael Burry are now saying that stock market bubbles are caused by passive investing. In 2022, approximately 20% of the shares of S&P500 were held in passive funds. Compare that to 3.3 percent in 2003.

The buy-and-hold approach to S&P500 is advised by even trading titans such as Warren Buffett, claiming it is one of the best options for passive investors.

Some people are now saying that long-term index investing has reached full saturation, and the market is lacking the buying power to maintain current prices. Something has to give, and the result is obvious.

Market signs that signify a burst

Just like water turning toxic when stagnant, the markets must also stay fluid. When buy and sell volumes both fall, volatility rises, investors and traders get cautious, and volume drops even more.

Recessions are a natural part of the economic cycle. The primary goal of a recession is brought on by the need for monetary policy to raise interest rates and cool down an overheated economy. This overheating is caused by the constant need to make this year better than last year. Growth, growth, growth. 

With the exception of emerging markets, the global market is finite. For a company to increase market share and grow, another company must suffer. Same with trading. For one trader to profit, another trader must lose. 

When the Federal Reserve starts to hike rates, bubbles expand and cycles of inflation begin. In turn, every currency in the world starts to follow a downward trajectory like dominoes. Those inflationary cycles are signs of a storm brewing, and 2022 Q3 and Q4 definitely laid the foundations for a correction in 2023.

Another sign of a bubble approaching instability is the quarterly employment reports. Employment usually peaks temporarily once the economic drop is underway. And yes, the US has been boasting about its unemployment levels for months.

The signs are undeniable.

The bottom line

It is likely that the 2022 Q4 rally was simply a correction during a long-term bear market, and not the beginnings of a bull market. So, bearish will probably continue into the new year with a few weak pushes throughout Q1. All eyes are on Q2.

A stock market crash will drive stock prices back to their valid intrinsic values. But, the 2022 slow correction might soften that blow considerably more than you might expect. Residual from 2022’s pre-recession damage control gave us an artificially induced bearish market from the highs of Jan 2022 till Q4. 

Despite all the media scaremongering and market sentiment, it’s important to remember that supply and demand will always drive the movement of stock values. Even in the case of the S&P500, the price movement will be determined by the volume of buying and selling at various levels, but those volumes are heavily influenced by sentiment.

In other words, stocks and indices were overpriced bubbles at the beginning of 2022. The banks of the world made efforts to reduce a recessionary impact on the world, which sunk stocks but also delayed the recession, which so many legitimate analysts said would happen in 2022. Stocks rebounded in Q4 because of the positive sentiment caused by the delayed recession, among other things.

Despite the banks' damage control, a downturn is still very likely. Shorting stocks is an option, but the risks and volatility are impossible to calculate. If and when the bubble bursts, all markets will react rapidly. If you’re going to ride the fall, timing is everything.

In the aftermath, there will be reduced trading volume within a very wide price range, and spotting the recovery rise will be very hard to time. If you do hit a buy order, you may have to wait several weeks or even months to see a worthy return, and there will be volatility along the way, so high leverage will present a risk to accounts, especially those with limited equity.

2023 is going to be challenging, but exciting times… especially for day traders. As the market gets back on it’s feat, some traders will make millions, most won’t. Trade wisely, don’t overextend your equity, and keep your eye on market sentiment.

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