Image Source: Pixabay

It's no secret that the stock market has been in a bubble for quite some time now. The question is, when will it burst? For you died-in-the-wool buy & holders, it shouldn't matter. But for the rest of us who want to preserve what we've gained over the last 3+ years, it matters a lot. 

I believe that every Investment Policy Statement (a written investment plan) should include a section called "Plan B," where the investor outlines what steps they will take when the bull market begins to roll over. How will you know when it's time? There are a number of indicators to watch, and when these indicators start to line up, it's time to play a little defense.

That could be something as simple as increasing your cash allocation, or as complex as hedging your entire portfolio with derivatives. I prefer the simple way, but how you play defense is entirely up to you. So, let's dig into these bubble-bursting indicators and take note of what they are telling us now. 

Complacency

When investors become complacent, it usually means that the good times are about to come to an end. This is the situation we are in today. What was once described as investor optimism about the AI infrastructure build has now morphed into investor overconfidence. There are signs all around us, so let's go through them one-by-one.

Narrow trading range

This chart shows the deceleration of upward momentum in the S&P 500. After the April swoon last year, the market recovered quickly. But ever since September, the market has been trading in a narrow range of about 5%.

Diminishing new high increments

This chart shows the shrinking of incremental new highs in the S&P 500. In a strong bull market, you would expect these hew highs to surpass the old highs by 0.50% or more. But the most recent new highs have seen much smaller increments.

Put/Call Ratio 

In a bull market, optimistic investors buy more calls than puts. That keeps the ratio below 1. But, when the ratio reaches an extremely low level, it is a sign that investors are no longer interested in hedging the downside. 

The current ratio stands at 0.58. The long term median ratio is 0.70. This is a classic sign of investor overconfidence.

Rapid snap-back rallies after market declines

In a normal, upward-trending market, we would expect to see buyers coming in to "buy the dips." What we're seeing today, though, is dip-buying on steroids. The classic example of this was the rapid snap-back after the Covid crash in 2020. Since then, investors have been buying the dips quickly, before they can turn into corrections. 

There are exceptions, like the bear market in 2022 and the April swoon in 2025. But, aside from these, we don't see many dips of more than 5%. Here's a chart that shows the dips and snap-backs over the past 12 months.

Bond market warnings

There is a widespread belief today that Treasury rates are headed lower. But this is not what's happening. For example, the rate on the 10yr Treasury bond has been inching higher since the end of October of last year. See the chart below.

The bond market usually senses trouble before the equity market does, and ignoring the bond market signals is a sign of complacency.

FOMO (Fear of missing out)

In a bull market, investors can reach a point where they feel under-invested and they can be overcome by a fear of missing out on the gains that others are making, This leads to herding behavior, where investors pile into crowded trades (like AI for example) regardless of how overvalued the market may be. 

The chart below shows what can happen when herding behavior takes over and sends a stock into a parabolic move higher.

Ignoring Macro signals

Many reports on the state of the economy are coming in better than expected. It's widely believed that we will avoid a recession this year, and GDP growth will start to pick up towards the end of the year.

But there are some indicators that are telling a different story, For example, the unemployment rate is ticking higher and job growth has slowed significantly. Companies are slashing their workforce as AI agents take over many of the routine tasks that were performed by salaried workers.

Anecdotally, I spoke with a Chief Information Officer a couple of weeks ago, and he told me that he could lay off 50% of his staff if he fully implemented AI to write code for the company.

Treasury Bond Bear Steepening

In a normal, upward-trending market, the yield curve remains intact, with short and long rates moving together and preserving term risk. But when long term rates are rising faster than short term rates, it's what bond traders call a "Bear steepening." This is a bearish signal for the economy, and for the stock market.

The Bottom Line

if you look at any of these indicators in isolation, there is no need to play defense when they start to signal trouble. But when the preponderance of these indicators are flashing warnings, it's only prudent to take steps - however small - to protect against what could turn into a major market decline. 

I am not calling for a bear market in the immediate future. In fact, my bear market econometric model says we only have a 27% chance that a bear market will begin sometime within the next 6 months. But, I am calling for more caution than normal, to counteract the extreme bullishness that has kept this market going since 2023.

Complacency is all around us, and that makes us vulnerable to downside risk. Stay long, because bubbles usually last longer that most people would think. But keep some extra cash on hand (I have 10% in cash right now). And keep an eye on the indicators I discussed in this article. If they get even worse, you might want to do a little de-risking of your portfolio.

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