Melt up is a financial term that refers to a sharp improvement in the performance of the stock market due to reasons other than fundamental improvements in the economy. The improvement in investment performance is mainly driven by investor sentiment, where investors flock into buying stocks because they notice the market rising, and they do not want to miss out on the opportunity.
The investors’ general optimism about the stock market encourages more investors to buy stocks in prominent companies with strong earnings points. However, the perceived rise in the stock market is caused by the general hype and dozens of investors taking advantage of the opportunity to profit, and not necessarily by the actual improvements in the economy.
The gains created by the melt up are considered unreliable economic indicators of the direction that the market will take, and a melt up is often followed by a financial meltdown.
Melt up refers to a sudden improvement in the price of a security due to investor sentiments.
Melt up occurs when investors flock into buying assets based on greed rather than fundamental improvements in the stock market.
Investors can avoid melt ups by focusing on economic indicators that measure the overall health of the economy and the direction that an investment will take.
Understanding Melt Ups
Stock market melt ups present a risk to investors since they are not caused by actual fundamental improvements in the economy. In most cases, melt ups share similar characteristics with panic buying since both are driven by a momentum that may not last in the long term.
Although most investors may be tempted to profit from the rising positions in the stock market, they should also understand that such movements last in the short term and the rising performance would be followed by a meltdown. Investors who let melt ups influence their decision are driven by emotions, and it is best to focus on doing due diligence to understand the actual value of an investment.
Traders can still capitalize on the short-term gains, but traders with a long-term perspective are better off making decisions based on market fundamentals. Fundamental analysis involves studying various elements such as the balance sheet, earnings, product lines, and other elements of a company that may influence the stock movements. It involves analyzing both qualitative and quantitative data to evaluate the financial health of a company and make a decision on whether or not to buy the company’s stocks.
The basis of fundamental analysis is to find stocks that are perceived to be undervalued and likely to grow over time. Therefore, investors who practice fundamental analysis are more interested in owning stocks that they will hold in the long term.
Using Economic Indicators to Recognize Melt Ups
For an investor to recognize a melt up when it occurs, they must understand the various economic indicators that determine the health of the securities market. Key economic indicators, such as leading and lagging indicators, are used to predict the overall health of the economy and can help predict the direction that an investment will take.
The economic indicators are covered in detail below:
Leading indicators are indicators that shift before the economy takes a particular direction, and they help policymakers predict significant changes in the economy. They are based on aggregate data provided by credible sources and are focused on specific segments. The identified leading indicators should be measurable so that investors can use the data to forecast where the economy is headed and refine their strategies based on how the anticipated market conditions may affect revenues.
For example, the Consumer Confidence Index (CCI) is one of the most accurate indicators and measures the general consumer perception and attitudes about the state of the economy. Another leading economic indicator is the Durable Goods Report (DGR), which surveys heavy manufacturers monthly and reports the financial health of the durable goods industry.
Lagging indicators are indicators that shift after the economy takes a particular direction, and they are used to confirm trends. Investors use these trends to gauge the trend of the economy and use the information to guide their decision-making process. Also, investors can use lagging indicators for general signals in a particular trend.
Most often, lagging indicators make up for the deficiencies of leading indicators, which are volatile and experience short-term fluctuations that can lead to false market signals. Examples of lagging indicators include the average cost of labor per unit of output and changes in the Consumer Price Index (CPI).
An example of a stock market melt up is the dot-com bubble that occurred between 1999 and 2000. During the period, stock prices were on the rise, and the momentum was driven by investor sentiment that was not based on fundamental or technical analysis of the stock market.
Investors bought stocks without realizing that the market growth was not based on any economic factors, and the value of stocks exceeded their intrinsic value. The greed ultimately led to the stock market bubble in early 2000 and its subsequent crash.
A bubble occurs when investors purchase stocks for the sole purpose of selling them to other investors, and when they stop buying, the bubble bursts, and the asset prices return to normalcy.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: