How to Spot and Avoid ETF Bubbles | ETF Trends

Bubbles are those pesky things that form when the interest in an area of the market takes on a life of its own, often leading to soaring performance in exchange traded funds (ETFs) and stocks. While bubbles can be dangerous, it’s easy to protect yourself from the effects.

We’ve all seen bubbles – undoubtedly the most infamous bubbles would be the stock market bubble that led to the Great Depression, the dot-com bubble of the 1990s and the real estate bubble of the 2000s.

Are you participating in a bubble? Elaine Scoggins for MarketWatch has a few signs:

  • You believe the experts are infallible
  • You start doing things that you swore you’d never do, like taking on more risk than you know you can handle
  • Strange behavior, like taking out huge loans to buy a home you can’t afford, not only seems normal, but like a wise move
  • Your emotions are running high
  • You believe the good times will go on indefinitely

Bubbles tend to follow a pattern: As a base begins to form, shares in the sector start to move up a bit compared to the rest of the market and then there’s some institutional buying. This all happens before the general public becomes aware. Once the idea spreads, the bull market begins within that sector. From there, bubbles become a self-fulfilling prophecy until they can no longer sustain themselves. (Is there a commodity bubble under way?)

Gary Gordon for ETF Expert notes that there are three ETFs that are in possible bubble mode right now. They are:

  • iPath UBS Copper ETN (NYSEArca: JJC): up 123.7% year-to-date
  • SPDR Gold Shares (NYSEArca: GLD): up 30.7% year-to-date
  • iShares JP Morgan Emerging Market Bond Fund (NYSEAcra: EMB): up 15.3% year-to-date

Many have noted that fixed income could be in a bubble, too. As the economy recovers, interest rates could rise and hit bonds hard.

How can you spare yourself the wrath of a bursting bubble? Rule number one: have a strategy.

We use a trend following strategy. It is easy to get caught inside of a bubble and then miss warning signs that are telling you to get out. This is why we have an 8% stop loss – once a fund declines 8% off the recent high or dips below its 200-day moving average, we get out. This protects us from further losses and eliminates emotional decision-making. More on trend following can be found in The ETF Trend Following Playbook. (Why trend following can help alleviate exposure to bubbles).

For more information about trend following, visit our trend following category.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.