Nicholas Colas, co-founder of DataTrek, developed a three-point checklist to spot unhealthy runaway markets that could lead to bubbles.

In a Morning Briefing report, he lists three signs of a dangerous bubble in U.S. stocks.

The first sign is in the market for initial public offerings (or IPOs), (NYSEARCA:IPO).

Most IPOs do not outperform in their first year or two. Also, during a hot IPO market, investors should get “as large an allocation as the underwriters will give you on every hot deal,” said Colas.

During their first days, IPOs can average 20-40% when they are rallying, and this “frothy” equity markets, he said, and gave two examples:

The IPOs of 1999 had a mean day-one gain of 71%, after never averaging more than 25% on their first day. There was an average of two IPOs per day that year, breaking records since 1980. “Scarcity value doesn’t explain the first day moves,” he said. “Irrational exuberance does. US equities peaked in March 2000.”

Then, in 2020 and 2021, the average first day IPO gains were 42% and 32%, respectively. There were 311 IPOs in 2021, the most since 2000. Also, the S&P (SP500) peaked in January 2022 and stayed bearish through much of that year.

This could mean that the markets today are not in bubble territory, since there were 54 IPOs last year, averaging 12% gain on their first day.

The second sign are “hallmark mergers and acquisitions deals.”

Since M&As are a function of the company’s confidence, sometimes bad deals are made due to inflated valuations. Colas gives two examples: AOL’s purchase of Time Warner in 2000 for $165B — “This was easily the worst high-profile M&A deal of all time, made possible by AOL’s inflated valuation during the peak of the dot com bubble — and KKR & Co (KKR) and TPG Inc.’s (TPG) purchase of Texas Utility TXU in 2007 for $32B, which was the largest leveraged buyout of all time. The company filed for bankruptcy in 2015.

“Exceptionally bad deals happen at the top, even if at the time they seem quite sensible,” Colas said. “Just like retail investors chasing hot IPOs at a market peak, senior managers fall prey to the same overconfidence that the good times will last forever.”

Currently, M&A activity is picking up after a slow 2023.

Finally, the third sign is what Colas calls “a double is a bubble.”

This is a rule of thumb to identify unsustainably high prices in a range of markets, he said.

As an example, since the 1970s, when oil prices double in a year — it happened in 1973-1974, in 1979-1980, in 1990, and in 2007 — there is a recession and crude prices decline.

Similarly, whenever the S&P (SP500) doubles in three years or less, stock prices tend to decline shortly thereafter, according to Jessica Rabe, co-founder of DataTrek. The same happens with the Nasdaq Composite (COMP.IND) over any rolling one-year window since the early 1970s.

“A double is sign of speculative excess because macro conditions are never so different that asset prices should rise 100% over a short period of time,” said Colas. “Markets are reasonably good discounting mechanisms. When prices double, you know speculation – not fundamentals – are driving those gains.”

Under this rule, although the Nasdaq Composite (COMP.IND) is “the frothiest equity market” currently, it is up 43% over the last year, not 100%.