How to spot a blowing bubble

It is very rare for this column to be lost for words but it does sometimes happen. A recent presentation at a school in Brighton, given to classes of 14-15 year olds on the subject of “how the stock market works”, came to a crashing halt when confronted by the question: “Since it’s so easy to spot a bubble after the fact, why can’t people do so beforehand?“

In theory a bubble should be easy to spot. As greed takes over, speculation overwhelms the fundamental premise of patient wealth accumulation through investment and buyers fall over themselves to pay seemingly any price for an asset simply because they think they can sell it to someone for more – a concept perhaps best described as the ‘greater fool theory.’ At this point vital issues such as valuation are simply tossed aside in the scramble to get involved, irrespective of the dangers.

And yet spotting when the bubble pops is still hard work. No-one rings a bell to call the top, as investors in Chinese equities have discovered since 12 June this year, and there is rarely a sudden obvious catalyst. Even if there was such a thing, the chances are it would be ignored as no-one wants the party to end – sellers, buyers or financial intermediaries taking their cut.

Ultimately it is better to head for the exit too early than too late, despite the frustration of lost profit-making opportunities this may bring, as pulling out too late means it can be hard to find the exit at all, let alone in a manner which allows investors to bank their previously hard-won gains. This explains the pithy response from the first Baron Rothschild when asked about the secret of his stock market success: “I made my fortune by selling too early.”

Even here, one person’s bull market is another’s accident waiting to happen but it is fair to say the following arenas in particular are coming under closer scrutiny for their bubbly tendencies

• Chinese equities
• Biotechnology stocks
• Bonds (especially sovereign issue in the West)
• Technology stocks and early-stage start-ups

China looks to be pulling out all the stops to support its equity market and Quantitative Easing (QE) in Europe is giving a bid to Eurozone Government paper, so perhaps biotech and to a lesser degree (early-stage) tech are the biggest accidents waiting to happen short term, as these areas’ lofty valuations offer the least protection should something go wrong. China comes next in this risk list, while it is possible bonds may offer more of a margin of safety than the others. If inflation and interest rates shoot higher then there may be trouble ahead, confirming the view of many that government bonds are no more than certificates of confiscation, but neither looks likely for now and the real yields on UK and US Treasuries still look acceptable, in a historical context.

Know the past, sense the future

Asset price bubbles episodes are depressingly common. They may all look different but history shows bubbles tend to have a similar shape, even if they come from different decades, or even centuries, and relate to different asset classes. The economist Charles P. Kindleberger’s seminal work Manias, Panics and Crashes outlines both the usual cycle represented by the formation and then collapse of a bubble, based on thorough study of the many examples offered over time.

The first step in the formation of a bubble is usually the appearance of a transformational opportunity, such as the chance to invest in trade flows with America, the railways, mines, real estate or a new technological development. The initial legitimate entrepreneurial profits then attract more capital, often made through the concurrent availability of cheap credit, which then facilitates further sound investment before matters get out hand and fraudsters appear to target the unwary.

Eventually someone, somewhere realises the price being paid for an asset is wrong – at the peak of the 1636-37 tulip bubble, bulbs were changing hands up to 20 times the average Dutch annual salary. The trouble then is no-one can get out, credit disappears, frauds are discovered and panic sets in as prices collapse.

In sum, buyers are interested in trading the asset, rather than owning it and are willing to pay any price to participate. Shrewd sellers who spot the disconnect between market price and fundamental value, as dictated by long-term profits and cashflows, are the ones who actually call the top but they do so without making a noise about it. After all, they want to get out unscathed and need the mug money to help them do so.

This is why experienced market commentators look for signs such as a rush of new flotations, disposals by private equity firms and the ratio of directors’ stock sales to purchases when it comes to judging just how long in the tooth a bull market really is. China’s flood of new issues was perhaps one tell-tale sign, while it should be worth keeping an eye on private equity activity in the USA. The always-interesting website www.valuewalk.com reveals that US private equity investment fell 1% quarter-on-quarter in Q2, while exits jumped 80% to a quarterly record of $125 billion.

US market has seen a rush of private equity exits

Source: Pitchbook, www.valuewalk.com

Price must be right

Shrewd money looking for a way out while hot money is still looking for a way in could be one sign of a top in some areas, especially as record-low interest rates are forcing cash to go looking for a home. Add that to record-high readings on Robert Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio and US market cap to GDP and it is easy to see why some market watchers are nervous.

That said, we must all be aware that valuation is not a marketing timing tool in the short term. Expensive markets can just get more expensive once the momentum jockeys take over. But in the long-term valuation does matter and will be a key determinant of future returns, so ultimately the multiple paid to access a stock, or real yield accepted when buying a bond, will have a huge – the only - say in how a portfolio pick does.

This is confirmed by research in James P. O’ Shaughnessy’s tome What Works on Wall Street. It looks at a 50-year period and which stocks performed best according to certain valuation metrics. In the long run, buying unloved, undervalued assets generated far better returns than going with the herd and chasing momentum.

Value looks to win out over momentum in the end

Source: James P. O’Shaughnessy, What Works on Wall Street.

Prior examples of how bubbles can pop include Japanese equities in the 1980s, technology stocks in the 1990s and commodity stocks in the noughties. Talk of it being different this time proved way off the mark, as usual, and those who were late to the party got fleeced.

Japanese equities boomed in the 1980s and have struggled ever since

Source: Thomson Reuters Datastream

It took US tech stocks 15 years to recapture the peak made in 2000

Source: Thomson Reuters Datastream

Mining stocks have fallen into a huge hole

Source: Thomson Reuters Datastream

Investors must now assess whether any of China, bonds or biotech, for example, are looking as frothy as the examples above eventually became.

Chinese equities have stumbled

Source: Thomson Reuters Datastream

Merger and acquisition activity continues to buoy biotech

Source: Thomson Reuters Datastream

Junk debt has enjoyed a huge bull run

Source: Thomson Reuters Datastream

The above chart looks at junk debt, where yields have only just started to rise from a skinny-looking record low of around 5%, but it is sovereign debt about which bond bears growly most loudly. With the yield on 10-year UK Gilts and 10-year US Treasuries down at 2.0% and 2.5% respectively, they offer little protection to clients’ cash should central banks reach (or exceed) their 2% inflation targets.

Yet as Lacy H. Hunt of Texan investment management firm Hoisington Capital points out in his firm’s second quarter review, inflation is still subdued. Moreover, the true value of bonds lies not with nominal yields but real, inflation-adjusted ones and the yields on offer today are around the historic norm. Under these circumstances Hunt argues US 10 and 30-year Treasuries bonds look no riskier than normal and the same applies to their UK equivalent, using this approach, according to our own research. Bubble-in-bonds talk therefore rests upon your view of where inflation goes from here and whether central banks succeed in their mission to drive it higher.

Real yield on US 10-year Treasuries is above its post-1997 average

Source: Thomson Reuters Datastream

Real yield on US 30-year Treasuries is in line with its post-1997 average

Source: Thomson Reuters Datastream

Real yield on UK 10-year Gilts is marginally below its post-1997 average

Source: Thomson Reuters Datastream

Real yield on UK 30-year Gilts is above its post-1997 average

Source: Thomson Reuters Datastream

Russ Mould

AJ Bell Investment Director