What is a 'Melt Up'?
A melt up is a dramatic and unexpected improvement in the investment performance of an 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 melt downs.
Understanding Melt Ups and Nuances of Economic Indicators
Ignoring melt ups and melt downs 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 are all forms of economic indicators, which investors follow to forecast the direction of the stock market 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.
- A melt up is a sudden rise in the price of an asset class due to investment by a stampede of investors interested in profiting from the gains in price.
- Melt ups are not indicative of fundamentals and can be avoided by focusing on economic indicators that provide an overall picture of the health of the US economy.
- In the stock market, melt ups in a stock's price can be avoided by focusing on the fundamentals of the stock's performance.
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.
Example 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.