A melt-up is a sustained and often unexpected improvement in the investment performance of an asset or asset class, driven partly by a stampede of investors who don’t want to miss out on its rise, rather than by fundamental improvements in the economy.
Gains that a melt-up creates are considered to be unreliable indications of the direction the market is ultimately headed. Melt-ups often precede meltdowns.
Key Takeaways
- A melt-up is a sudden, persistent rise in the price of a security or market, often due to investor herding.
- Melt-ups are not necessarily indicative of a fundamental shift and may reflect market psychology instead.
- Poor decisions to buy into a melt-up can be avoided by focusing on economic indicators that provide an overall picture of the health of the US economy or on the fundamentals of a stock.
Understanding Melt-Ups and Nuances of Economic Indicators
Ignoring melt-ups and meltdowns and instead focusing on fundamental factors begins with an understanding of economic indicators. Economic indicators come in the forms of leading indicators and lagging indicators. These forms of economic indicators are vital as investors use them to forecast the stock market’s direction and overall health of the U.S. economy.
Leading indicators are factors that will shift before the economy starts to follow a particular pattern. For example, the Consumer Confidence Index (CCI) is a leading indicator that reflects consumer perceptions and attitudes. Are they spending freely? Do they feel like they have less cash to work with? A rise or fall of this index is a strong indication of the future level of consumer spending, which accounts for 70% of the economy.
Additional leading indicators include the Durable Goods Report (DGR), developed from a monthly survey of heavy manufacturers, and the Purchasing Managers Index (PMI), another survey-based indicator that economists watch to predict gross domestic product (GDP) growth.
Lagging indicators shift only after the economy has begun to follow a particular pattern. These are often technical indicators that trail the price movements of their underlying assets. Certain examples of lagging indicators are a moving average crossover and a series of bond defaults.
Melt-Ups and Fundamental Investing
Many investors attempt to avoid melt-ups and their impact on investor emotions when placing bets by instead focusing on the fundamentals of companies. Warren Buffett, for example, is a famous value investor, who made his fortune by careful attention to companies’ financial statements, even amid economic turmoil. He focused on corporate value and price: Was the company on solid financial footing? How experienced and reliable was the management? And was it over- or under-priced? These questions often help investors focus on intrinsic value over hype.
Examples of Melt-Ups
Financial analysts saw the run-up in the stock market in early 2010 as a possible melt-up, because unemployment rates continued to be high, both residential and commercial real estate values continued to suffer, and retail investors continued to take money out of stocks.
More examples of melt-ups occurred during the Great Depression, when the stock market rose and fell several times despite a generally weak economy. According to research by wealth managers, stocks fell by more than 80% between 1929 and 1932. But they posted returns of more than 90% in July and August of 1932 and the trend continued over the next six months.
