Spotting market bubbles

by George Hatjoullis

Bubbles in a washing-up bowl

Bubbles in a washing-up bowl (Photo credit: Wikipedia)

The Economist has published an article in which it concludes “The lesson of history is that it’s nearly impossible to know whether a price boom was or was not a bubble without the benefit of a comfortable period of hindsight” (http://econ.st/1fSeGJl). This is not quite the case. I have experienced many bubbles, some large, some small, but all with consistent, observable characteristics. The problem is not that one does not know one is in a bubble but rather one does not know when it will burst. It is the bursting that can only be known with hindsight. So what are these characteristics?

In a bubble the trading activity becomes dominated by purely speculative activity. Such activity is clear because people buy and sell simply for capital gain. No one looks at income streams. The assets in question may have no income stream and the current valuation would only be justified on the basis of truly heroic assumptions about future income. The ‘dot.com’ bubble is a good example. The response to old style investors that think assets should be valued based on income streams is that ‘ it is different this time‘. Indeed if there is a single expression that will define a bubble it is this.

Behaviour in a bubble is also materially different. Higher prices are the sole justification for investment. Individuals that do not normally invest in the asset in question and have little knowledge of the nature of the asset or the market will become numerous. The investors will not be natural investors or consumers of the underlying asset. They will know little about it and have no intrinsic use for it. They are in it for the capital gain. Confidence in the success of the investment will be very high and exposure will be high. Leveraged investors will be common and portfolios will typically be over-committed to this asset class. Why not, it is different this time.

The market will become effectively one-way. No one will want to be short and all will be looking to buy. All metrics will be flashing extreme overbought. The press will mention the asset class frequently and it will be hard to find comments from doubters. People you know that have normally glazed over whenever economics or finance entered the conversation suddenly become animated and are eager to discuss the asset in question. Many will have invested even though they had never gone beyond a deposit account before. Everyone has an opinion and everyone is an expert and you are a fool for not participating. When you do it will be precisely when the bubble will burst.

The key test for identifying a bubble (this is for regulators) can be found in catastrophe theory. Look at how the bubble might respond to small variations in conditions. How big a price drop would be required to bring distress to the collection of speculators? How big a variation in the cost or availability of credit would undermine the leveraged investor? What, albeit crazy, market narrative is driving the bubble and how might this deviate and what might be the reaction? If the present narrative implies that prices can rise indefinitely, without any material setback, you are in a bubble. There is, however, no way of knowing when it will burst, much like a real soap bubble.

The correct response to bubbles is not to respond to them as such. If you are running a well diversified portfolio you will have only limited exposure to the asset class in any case. If you are sensitive to valuations and income streams you may have very little exposure. You will be one of the ‘fools’ that did not get rich quick chasing a bubble. Some people do get rich in bubbles and pass on the toxic asset to someone else. But ask yourself, before getting involved, is that you?

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