Showing posts with label phases of bubble. Show all posts
Showing posts with label phases of bubble. Show all posts

Sunday 23 July 2023

How to identify potentially threatening asset price bubbles?

In a globalized world, with few barriers to capital flows, investors around the world can bid up prices for stocks, bonds and real estate in local markets from New York to Shanghai.  

Central banks have fueled these purchases with record low interest rates and by entering the bond market as major buyers themselves  

Largely as a result, global financial assets (including only stocks and bonds) are worth $280 trillion and amount to about 330% of global GDP, up from $12 trillion and just 110% in 1980.


Traditionally, economists have looked for trouble in the economy to cause trouble in the markets.  

They see no cause for concern when loose financial policy is inflating prices in the markets, as long as consumer prices remain quiet.  

Even conservatives who worry about easy money "blowing bubbles" still look mainly for economic threats to the financial markets, rather than the threat that overgrown markets pose to the economy.   

But financial markets are now so large, that the tail wags the dog.

A market downturn can easily trigger the next big economic downturn.


Summary:

The general rule is that strong growth is most likely to continue if consumer prices are rising slowly, or even if they are falling as the result of good deflation, driven by strengthening supply network.

In today's globalized economy, in which cross-border competition tends to suppress prices for consumer goods but drive them up for financial assets, watching consumer prices is not enough.  

Increasingly, recessions follow instability in the financial market.  

To understand how inflation is likely to impact economic growth,  keep an eye on stock and house prices too.



Housing bubbles and Stock bubbles fueled by borrowings

Be alert when prices are rising at a pace faster than underlying economic growth for an extended period, particularly for housing.  

  • Home prices typically rise by about 5% a year.  
  • This pace speeds up to between 10% and 12% in the two years before a period of financial distress.
  • Once prices for stocks or housing rise sharply above their long-term trend, a subsequent drop in prices of 15% or more signals that the economy is due to face significant pain.  

In general, housing bubbles were much less common than stock bubbles but were much more likely to be followed by a recession.  The downturn is much more severe if borrowing fuels the bubble.  

  • When a recession follows a bubble that is not fueled by debt, 5 years later the economy will be 1% to 1.5% smaller than it would have been if the bubble had never occurred.
  • If the investors borrow heavily to buy stock, the economy 5 years later will be 4% smaller.
  • If they borrow to purchase housing, the economy will be as much as 9% smaller.


Thursday 10 December 2020

The 4 basic signs of a stock bubble

 There are four basic signs of a stock bubble:

1.  high levels of borrowing for stock purchases;

2.  prices rising at a pace that can't be justified by the underlying rate of economic growth;

3.  overtrading by retail investors; and

4.  exorbitant valuation.


In 2015, the Shanghai market had reached the extreme end of all four bubble metrics which is rare.  

The amount that Chinese investors borrowed to buy stock had set a world record, equal to 9% of the total value of tradable stocks.

Stock prices were up 70% in just 6 months, despite slowing growth in the economy.

On some days, more stock was changing hands in China than in all other stock markets combined.


In April 2015, the state-run People's Daily crowed that the good times were "just beginning."

In June 2015 the Shanghai market started to crash, and it continued to crash despite government orders to investors not to sell.




Monday 16 March 2020

Stock Market Bubble Threat

Stock Market Bubble Threat

By Jomo Kwame Sundaram



KUALA LUMPUR, Malaysia, Mar 11 2020 (IPS) -


The US is currently still in a stock market bubble which, if history is any guide, is likely to end, as argued by Thomas Palley. While President Trump would, of course, like to sustain it to strengthen his November re-election prospects, the Covid19 black swan is already showing signs of pricking the bubble

Meanwhile, US business investment has declined for many years. As shares of GDP, corporate profits or even market capitalization, such investment has been in decline for at least four decades. Clearly, ‘neo-liberal’ economic policies have failed to decades-long trend.


Financialization ‘unreal’

Julius Krein has underscored some dangerous financialization trends. Global stocks are now worth almost US$90 trillion, more than world output. Including equities, bank deposits, (government plus private) debt securities, etc., the total value of financial assets rose from US$118 trillion in 2004 to over US$200 trillion in 2010, more than double world output then.

Half of Americans own no stocks, while just ten per cent own over 80 per cent of equities, and the top one per cent has almost 40 per cent. With no increase in real investments, more funds in financial markets have served to worsen wealth inequality.

‘Capital returns’ in 1980, in the form of share buybacks and dividends, were about two per cent of US GDP, when real investment was close to 15 per cent. By 2016, real investment had fallen to around 12 per cent of output, while capital returns had risen to about 6 per cent.

Ironically, in an age of ostensible globalization, rising capital returns has become increasingly national in some economies, rather than involving cross-border capital flows, which fell from US$12.4 trillion in 2007 to US$4.3 trillion, i.e., by 65%.

The rise of finance, at the expense of the real economy, over the last four decades has slowed productive investments and economic growth, ending the post-war Keynesian Golden Age quarter century. Meanwhile, as profit rates declined, debt has increased.



Inflating stock market bubbles

Since the 1980s, as Palley has shown, ‘engineered’ US stock market bubbles have obscured lessons from preceding busts, explaining them away as Schumpeterian creative destruction. While each new bubble may retrieve some of the preceding loss, it never fully restores earlier economic gains.

Investors buy stock, expecting to sell at higher prices. Such purchases push up share prices, drawing new investors into the price appreciation spiral. The share price bubble continues to inflate until faith in ever rising prices ends, with the bubble imploding when enough buyers start selling.

Each new stock market bubble seduces share market punters to invest ever more, to gain even more, while obscuring public understanding of the economic malaise. And when prices fall, many shareowners hold on to their stocks, hoping for prices to recover, to make more, or at least, to cut losses.

Thus, stock market dynamics resemble Ponzi frauds, with earlier investors profiting from new investments. Handsome gains draw in more investments until even these are insufficient to meet rising expectations. Changes in market sentiments can slow the bubble’s growth, or cause reversals, even collapse.

Along the way, all investors feel richer, triggering wealth effects and market exuberance, typically irrational. When downturns occur, many are too embarrassed to admit to losses, especially if they have induced others, relatives and friends, to invest.

Thus, the dynamics of stock market speculative bubbles are akin to a collectively self-inflicted fraud as most retail investors lack the ‘inside’ information needed to make sound portfolio investment judgements.



Promoting stock market addiction

The US Federal Reserve’s apparent commitment to the stock market since Alan Greenspan was in the chair, and its growing, albeit varying influences on financial asset prices has been seen as giving the green light to speculation, enabling serial asset price bubbles over at least three decades.

Despite its balanced official mandate, unsurprisingly, US Fed leadership is widely believed to favour Wall Street, while mainstream economists view asset price inflation as the unavoidable price of overcoming recession, sustaining economic growth and the bubble’s wealth effect.

Unlike the Roosevelt era, when economic policy and war achieved full employment and improved labour conditions, decision-making in recent decades has been seen as better serving capital, with the bias justified by insisting that the interests of capital and labour are ‘joined at the hip’.

With 401K (a US employer sponsored retirement savings plan allowing employees to invest a portion of their salaries before taxes) and other investments in the stock market, widespread ‘middle class’ addiction to stock price inflation has also been economically and politically self-deluding.

But despite the sustained US stock market bubble after the 2008-2009 global financial crisis, the US ‘middle class’ continues to be economically squeezed, with relatively few having benefited significantly.

This stock market addiction is rooted in an illusion promoted by Wall Street, their enablers in the public authorities, and their cheerleaders among mainstream economists and the business media who identify the notion of shared prosperity with stock market indices.

But the history and dynamics of stock market bubbles imply that they simply cannot be the basis for shared prosperity, as suggested by all too many emerging markets’ governments. Sadly, wishful thinking to the contrary perpetuates the mass delusion promoted and perpetuated by those who stand to gain most.

Stock market bubbles serve to obscure the dangers of neoliberal financialization for the economy. Demystification of obfuscating narratives can not only improve public understanding of the problems, dangers and challenges involved, but also inform the reforms needed to address them.


http://www.ipsnews.net/2020/03/corrected-version-stock-market-bubble-threat/?utm_source=English+-+IPS+Weekly&utm_campaign=632464bdfe-EMAIL_CAMPAIGN_2020_03_15_04_37&utm_medium=email&utm_term=0_eab01a56ae-632464bdfe-5479385&fbclid=IwAR3nWVA4e7I-IeHH88Vu2BjDk1zKs054pSBUVX108-1Ly9GukR0rBDEV79w


Saturday 14 January 2017

Speculators, Investors and Market Fluctuations


Speculators versus Investors


Mark Twain mentioned the two times in life when one shouldn't speculate: "when you can't afford it, and when you can!". 

Speculators buy in the hopes or assumptions that others will want to buy the same asset (be it a painting, a baseball card, or a stock) later.

Investors buy the cash flow the investment returns to its owner. (As such, a painting can never be an investment by this definition!)



Stock Market Bubbles

Bubbles in the stock market form due to faulty logic that first propels speculators to bid up prices followed by the inevitable bursting which destroys the wealth of many.



What determines whether an investor will make money in the market or not?  

The answer is his psychological make-up. 

If he does his own stock analysis and views the prices offered by Mr. Market as an opportunity to buy low and sell high, he will do fine. 

If Mr. Market's offering prices guide the investor's outlook of what the stock price should be, he should get someone else to manage his money!



Market fluctuations

Most market fluctuations are the result of day-to-day distortions between supply and demand of particular stocks, not of changes in fundamentals.

Investors who take advantage of these distortions by focusing on the fundamentals will be successful. 

Those who invest with their emotions are sure to fail in the long-run.





Read also:

Thursday 4 August 2016

A Random Walk Down Wall Street - Part One 3: Stocks and Their Value

Chapter 2. The Madness of Crowds

The psychology of speculation is a veritable theater of the absurd. Although the castle-in-the-air theory can well explain such speculative binges, outguessing the reactions of a fickle crowd is a most dangerous game. Unsustainable prices may persist for years, but eventually they reverse themselves.

I. the Tulip-Bulb Craze

1. In the early 17th century, tulip became a popular but expensive item in Dutch gardens. Many flowers succumbed to a nonfatal virus known as mosaic. It was this mosaic that helped to trigger the wild speculation in tulip bulbs. The virus caused the tulip petals to develop contrasting colored stripes or “flames”. The Dutch valued highly these infected bulbs, called bizarres. In a short time, popular taste dictated that the more bizarre a bulb, the greater the cost of owning it.

2. Slowly, tulipmania set in. At first, bulb merchants simply tried to predict the most popular variegated style for the coming year. Then they would buy an extra large stockpile to anticipate a rise in price. Tulip bulb prices began to rise wildly. The more expensive the bulbs became, the more people viewed them as smart investments.

3. People who said the prices could not possibly go higher watched with chagrin as their friends and relatives made enormous profits. The temptation to join them was hard to resist; few Dutchmen did. In the last years of the tulip spree, which lasted approximately from 1634 to early 1637, people started to barter their personal belongings, such as land, jewels, and furniture, to obtain the bulbs that would make them even wealthier. Bulb prices reached astronomical levels.

4. The tulip bulb prices during January of 1637 increased 20 fold. But they declined more than that in February. Apparently, as happens in all speculative crazes, prices eventually got so high that some people decided they would be prudent and sell their bulbs. Soon others followed suit. Like a snowball rolling downhill, bulb deflation grew at an increasingly rapid pace, and in no time at all panic reigned.


II. The South Sea Bubble

1. The South Sea Company had been formed in 1711 to restore faith in the government’s ability to meet its obligations. The company took on a government IOU ( I owe you: debt) of almost 10 million pounds. As a reward, it was given a monopoly over all trade to the South Seas. The public believed immense riches were to be made in such trade, and regarded the stock with distinct favor.

2. In 1720, the directors decided to capitalize on their reputation by offering to fund the entire national debt, amounting to 31 million pounds. This was boldness indeed, and the public loved it. When a bill to that was introduced in Parliament, the stock promptly rose from £130 to £300. 3. On April 12, 1720, five days after the bill became law, the South Sea Company sold a new issue of stock at £300. The issue could be bought on the installment plan - £60 down and the rest in eight easy payments. Even the king could not resist; he subscribed for stock totaling £100,000. Fights broke out among other investors surging to buy. The price had to go up. It advanced to £340 within a few days. The ease the public appetite, the company announced another new issue – this one at £400. But the public was ravenous. Within a month the stock was £550, and it was still rising. Eventually, the price rose to £1,000.

4. Not even the South See was capable of handling the demands of all the fools who wanted to be parted from their money. Investors looked for the next South Sea. As the days passed, new financing proposals ranged from ingenious to absurd. Like bubbles, they popped quickly. The public, it seemed, would buy anything.

5. In the “greater fool” theory, most investors considered their actions the height of rationality as, at least for a while; they could sell their shares at a premium in the “after market”, that is, the trading market in the shares after their initial issue.

6. Realizing that the price of the shares in the market bore no relationship to the real prospects of the company, directors and officers of the South Sea sold out in the summer. The news leaked and the stock fell. Soon the price of the shares collapsed and panic reigned. Big losers in the South Sea Bubble included Isaac Newton, who exclaimed, “I can calculate the motions of heavenly bodies, but no the madness of people.”

III. Wall street lays an egg

1. From early March 1928 through early September 1929, the market’s percentage increase equaled that of the entire period from 1923 through early 1928.

2. Price manipulation by “investment pools”: The pool manager accumulated a large block of stock through inconspicuous buying over a period of weeks. Next he tried to enlist the stock’s specialist on the exchange floor as an ally. Through “wash-sales” (buy-sell-buy-sell between manager’s allies), the manager created the impression that something big was afoot. Now, tip-sheet writers and market commentators under the control of the pool manager would tell of exciting developments in the offing. The pool manager also tried to ensure that the flow of news from the company’s management was increasingly favorable – assuming the company management was involved in the operation. The combination of tape activity and managed news would bring the public in. Once the public came in, the free-for-all started and it was time discreetly to “pull the plug”. Because the public was doing the buying, the pool did the selling. The pool manager began feeding stock into the market, first slowly and then in larger and larger blocks before the public could collect its senses. At the end of the roller-coaster ride the pool members had netted large profits and the public was left holding the suddenly deflated stock.

3. On September 3, 1929, the market averages reached a peak that was not to be surpassed for a quarter of a century. The “endless chain of prosperity” was soon to break. On Oct 24 (“Black Thursday”), the market volume reached almost 13 million shares. Prices sometimes fell $5 and $10 on each trade. Tuesday, Oct 29, 1929, was among the most catastrophic days in the history of the NYSE. More than 16.4 million shares were traded on that day. Prices fell almost perpendicularly.

4. History teaches us that very sharp increases in stock prices are seldom followed by a gradual return to relative price stability.

5. It is not hard to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges.


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

Tuesday 26 March 2013

Humbling Lessons from Parties Past by Burton G. Malkiel


HUMBLING LESSONS FROM PARTIES PAST
By BURTON G. MALKIEL
The ‘Elec-tronic” boom of 60s, the Nifty 50s boom of 70s, the Biotech boom of 80s and the Technology Bubble of 90s.
BENJAMIN GRAHAM, co-author of "Security Analysis," the 1934 bible of value investing, long ago put his finger on the most dangerous words in an investor's vocabulary: "This time is different."
Pricing in the stock market today suggests that things really are different.
Growth stocks,  especially those associated with the information revolution, have soared to dizzying heights  while the stocks of companies associated with the older economy have tended to languish.
Well over half the stocks on the New York Stock Exchange and Nasdaq are selling at lower prices today than they did on Jan. 1, 1999.
It is not unusual today for new Internet issues to begin trading at substantial multiples of their offering prices.
And after the initial public offerings, day traders rapidly exchange Internet shares as if they were Pokémon cards for adults.
As we enter the new millennium, how can we account for the unusual structure of stock prices?
Does history provide any clues to sensible strategies for today's investors?
To be sure, we are living through an information revolution that is at least as important as the Industrial Revolution of the late 19th century.
And much of the current performance in the stock market can be traced to the optimism associated with "new economy" companies - those that stand to benefit most from the Internet.
The information revolution will profoundly change the way we learn, shop and communicate.
But the rules of valuation have not changed.
Stocks are only worth the present value of the cash flows they are able to generate for the benefit of their shareholders.
It is well to remember that investments in transforming technologies have not always rewarded investors.
Electric power companies, railroads, airlines and television and radio manufacturers transformed our country, but most of the early investors lost their shirts.
Similarly, many early automakers ended up as road kill, even if the future of that industry was brilliant.
Warren E. Buffett, chief executive of Berkshire Hathaway and a disciple of Graham, has sensibly pointed out that the key to investing is not how much an industry will change society, but rather the nature of a company's competitive advantage, "and above all the durability of that advantage."
Yet the Internet must rely for its success on razor-thin margins, and it will continue to be characterized by ease of entry.
A drug company can develop a new medication and be given a 17-year patent that can be exploited to produce above-average profits.
No such sustainable advantage will adhere to the dot-com universe of companies.
Moreover, the "old economy" companies may not be nearly as geriatric as is commonly supposed.
We still need trucks to transport the goods of e-commerce, as well as steel to build the trucks, gasoline to make them run and warehouses to store the goods.
Precedents of recent decades offer many valuable lessons to today's investors.
Consider the "tronics boom" of 1960-61, a so-called new era in which the stocks of electronics companies making products like transistors and optical scanners soared.
It was called the tronics boom because stock offerings often included some garbled version of the word "electronics" in their titles, just as "'dot-com" adorns the names of today's favorites.
More new issues were offered than at any previous time in history.
But the tronics boom came down to earth in 1962, and many of the stocks quickly lost 90 percent of their value.
Another parallel to today's market was seen in the 1970's, when just 50 large-capitalization growth stocks, known as the Nifty 50, drew almost all the attention of individual and institutional investors.
They were called "one decision" stocks because the only decision necessary was whether to buy; like family heirlooms, they were never to be sold.
In the early part of that decade, price-to-earnings multiples of Nifty 50 stocks like I.B.M., Polaroid and Hewlett Packard rose to 65 or more while the overall market's multiple was 17.
The Nifty 50 craze ended like all others; investors eventually made a second decision -- to sell -- and some premier growth stocks fell from favor for the next 20 years.
The biotechnology boom of the early 1980's was an almost perfect replica of the microelectronics boom of the 1960's.
Hungry investors gobbled up new issues to get into the industry on the ground floor.
P/E ratios gave way to price-to-sales ratios, then to ratios of potential sales for products that were only a glint in some scientist's eye.
Stock prices surged.
Again, as sanity returned to the market and more realistic estimates of potential profits were made, many biotechnology companies lost almost all of their value by the early 1990's.
The lessons here are clear. Occasionally, groups of stocks associated with new technologies get caught in a speculative bubble, and it appears that the sky is the limit.
But in each case, the laws of financial gravity prevail and market prices eventually correct.
The same is likely to be true of the dazzling stocks in today's market.
Few of the Internet darlings will ever justify their current valuations, and many investors will find their expectations unfulfilled.
Even supposedly conservative index-fund investors may be surprised to know that very significant shares of their portfolios are invested in information technology companies whose P/E and price-to-sales ratios vastly exceed even the sky-high multiples reached during those past periods of market speculation.
At the very least, investors might well start the year by examining their portfolios, to see if their asset allocations are appropriate for their stage in life and their tolerance for risk.
Burton G. Malkiel is an economics professor at Princeton University and the author of “A Random Walk Down Wall Street" (W.W. Norton).
http://www.alphashares.com/OpEd_Humbling_Lessons.pdf

Thursday 1 March 2012

Gold: Bubbles blown large enough inevitably pop. “What the wise man does in the beginning, the fool does in the end.”


The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative.

  • True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. 
  • Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.


What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct.

  • Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. 
  • As “bandwagon” investors join any party, they create their own truth – for a while.


Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. 

  • In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. 
  • But bubbles blown large enough inevitably pop. 
  • And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”


Today the world’s gold stock is about 170,000 metric tons.

  • If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) 
  • At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.


Let’s now create a pile B costing an equal amount.

  • For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). 
  • After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). 
Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. 

  • Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.


A century from now

  • the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. 
  • Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). 
  • The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Thursday 20 January 2011

Market Behaviour: Irrational Exuberance

When a bull run goes on for too long, it can morph into irrational exuberance.  People tend to think that the market has changed and that stock will continue to go up forever.  In reality, it won't - instead, a stock market bubble is gradually inflating.

Unfortunately, most people get caught in the hype and continue to buy while the bubble continues to inflate.  Then that bubble bursts without warning, sending shares of stock down 50 percent and more.  Asset bubbles have formed repeatedly over time, but most people can't recognize a bubble until after it bursts.

The most recent stock bubble was the Internet stock bubble, which inflated in the 1990s and burst in the early 2000s.  Many people who got caught up in Internet stocks lost 50% to 70% on their portfolio - and some lost as much as 90%.

Value investors such as Warren Buffett didn't play in that market.  Value investors will not buy a stock that doesn't have a proven cash flow.  Internet stocks were losing money every year.  Most hadn't even figured out how they would make a profit.  Yet analysts recommended them based on future earnings projections.

If you can't figure how a company will generate its cash flow, walk away from it.  Don't ever get caught up in promises of future earnings that have not yet materialized.



Related topics:

Saturday 9 October 2010

Sorry to burst your bubble, your investment is overpriced

Annette Sampson
October 9, 2010

They're frothy and insubstantial. Mere lightweights in the world of solid matter. But bubbles can prove mighty dangerous phenomena, especially in the world of investments.

Investment bubbles have been brought back into focus by the mere uttering of the word by the Reserve Bank head of financial stability, Luci Ellis, in relation to the residential property market at a conference in Brisbane this week.

Let's be quite clear. Despite continuing speculation that Australian house prices are in bubble territory this was not what Ellis was claiming. Rather, Ellis said the market was showing ''welcome signs'' of cooling. But low yields on residential property, she said, limited the potential for price appreciation.

Advertisement: Story continues below ''Buying an asset because you expect the price to rise in the future, well, that is actually the academic definition of a bubble,'' were the attention-grabbing words. ''So that would be undesirable and seen as a problem.''

Never mind that future capital gains have long been the prime motivation for Australian residential property investors. Ellis said recent rises in rental yields and a levelling off in prices were a good thing, but this has not dampened the speculation over whether Australia, like the US and so many other countries, is in danger of a housing bubble burst.

The International Monetary Fund also bought into the housing bubble debate this week cautioning that our house prices may be overvalued and a correction could hit household wealth and consumer confidence.

The arguments on the Australian housing market have been well-documented. Those holding the bubble view point to historically high levels of debt by households, high house prices in relation to incomes, and low rental yields as being unsustainable. The property bulls point to continuing undersupply of housing and strong immigration as putting a floor under house values.

Both have a point. But in the post global financial crisis environment where debt still has the potential to derail the economic recovery, it would certainly be prudent to err on the side of caution.

However the argument raises the broader issue of how investors can shield themselves from the inevitable crashes that follow investment bubbles, while enjoying some of the profits while markets are rising.

As the chief economist of AMP Capital Investors, Shane Oliver, points out, investment asset bubbles are an inevitable outcome of human nature. Investors have a natural inclination to jump onto popular fads by buying into investments that have been star performers - a trend that pushes prices up further and further until they become overpriced and unsustainable.

While you would think investors would be once bitten, twice shy, history also shows that bubbles emerge regularly, often arising from the ashes of the most recent crash. While it's easy to get caught up in bubbles, the fact that we've had so many of them also provides investors with the tools to identify when and where bubbles are emerging. There are always those who will claim each bubble is different, but the reality is that they all follow similar patterns. The signs are there for those prepared to look for them.

Dr Oliver identifies a combination of conditions that tend to lead to bubbles.
  • Chief among these is a supply of easy money, though the bubble generally does not start to form until something happens that generates popular interest in the investment, it becomes overvalued, and speculators jump in fearing that if they don't buy now they'll miss out on the next chance to make some fast profits.
  • Other commentators have pointed out that bubbles are also characterised by overconfidence. Even when it is obvious that prices are overvalued, pundits come up with arguments to justify why ''this is different'' or why the old rules don't apply to this investment. A classic example was the tech boom of the late 1990s when any company claiming a vague connection to information technology could command a heady price on the sharemarket regardless of its earnings. Indeed, even if it had no earnings.
  • Another common feature of bubbles is that they are generally fostered by government policy that encourages speculation to grow.

Oliver says the liquidity that has been generated by governments in response to the global financial crisis and the bursting of the bubble in US house prices has created fertile conditions for the next bubble. Easy money is providing the fuel for investors to jump into something seen as safe, offering a good return, and removed from the assets that caused the last set of problems.

His pick of prime bubble candidates are shares in emerging markets, gold and commodity prices, and resource shares.

However for a bubble to exist, speculation and overvaluation must also be present - and while there is definitely speculation in these markets, and prices have risen strongly, Oliver argues they have not yet reached bubble levels.

His verdict is that we are in the ''foothills'' of the next bubble, which more than likely has several years to run.

It is also important to note that while the most memorable bubbles are those that come to a spectacular end, not all investment bubbles lead to a sudden collapse in prices. Bubbles can end with a bang, or they can simply run out of steam, providing investors with a long period of underperformance rather than overnight losses. Historically this has been the more common trend for less volatile (and less liquid) assets such as direct property investments.

In that respect, a cooling in Australian house prices should indeed be welcomed.


http://www.smh.com.au/business/sorry-to-burst-your-bubble-your-investment-is-overpriced-20101008-16bz5.html

Tuesday 11 May 2010

Why do bubbles sometimes last so long?

Bubbles are fueled by speculators who are willing to pay even greater prices for already overvalued assets sold to them by the speculators who bought them in the preceding round.

Each financial bubble in history has been different, but they all involve a mix of fundamental business and psychological forces.  In the beginning stages, an attractive return on a stock or commodity drives prices higher and higher.  People make questionable investments with the assumption that they will be able to sell later at a higher price to a "greater fool."  Unrealistic investor expectations take hold and become self-fulfilling until the bubble "pops" and prices fall back to a more reasonable underlying value.

Why do bubbles sometimes last so long?   One reason is that nobody likes to be a "party pooper" and people ARE getting rich.  In addition, there is nothing inherently illegal about profiting during a bubble.  The only problem is getting out BEFORE the collapse.  Whoever owns the overpriced asset when the bubble pops is the loser, just as the last person standing in a game of musical chairs.

17th century in Holland:  Tulip Bulbs bubble (1630s)
1995 - 2001:  Technology Stocks bubble
2007:   U.S Housing Crisis bubble

Investing in bubbles can be quite profitable if you can get out before the bubble bursts.  However, many people who did not get out before the 'pop' saw their market crashed and their wealth value evaporated.

Bubbles are not caused by fraudulent activity.  However, swindles and accounting fraud often come to light just after bubbles pop.  Nobody is looking and few care while the good times roll.  Highly leveraged frauds often run out of cash and collapse when bubbles pop.

1963:  Salad Oil Scandal
2001:  Enron
2002:  WorldCom


Comment:  
Is the economy in a bubble?  Is the present market a bubble?  A definite not.  However, some individual stocks had been speculated up to bubble proportions and some had already popped.  Individual stock bubbles are a lot  more common than whole market bubble.

Wednesday 30 December 2009

THE PAUSE AT THE TOP OF THE ROLLER COASTER

There is only one strategy that works for value investors when the market is high – patience. The investor can do one of two things, both of which require steady nerves.

· Sell all stocks in a portfolio, take profits, and wait for the market to decline. At that time, many good values will present themselves. This may sound easy, but it pains many investors to sell a stock when its price is still rising.

· Stick with those stocks in a portfolio that have long-term potential. Sell only those that are clearly overvalued, and once more wait for the market to decline. At this time, value stocks may be appreciating at slow pace compared with the frisky growth stocks, but not always.

But come the correction, be it sudden or slow, the well-chosen value stocks have a better chance of holding their price.

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http://myinvestingnotes.blogspot.com/2009/01/pause-at-top-of-roller-coaster.html

The portfolio of one value investor shows what can happen when markets stumble off a cliff. In early September 1987, Walter Schloss’s portfolio was up 53%. The market as a whole had risen 42%, after a DJIA peak of 2722.42. Then in October the market fell off the mountain and the Dow lost 504 points in a single day. The market struggled back and Schloss finished 1987 with a 26% gain while the overall market made only a 5% advance. Schloss followed one of the first rules of investing – don’t lose money. Making up for lost ground puts an investor at a serious disadvantage when calculating long-term average returns.


Schloss is an experienced investor, and not all value investors will do as well in a rising market. It takes patience, “At a guess I’d say that (the value investor) should do a good 20% better than the market over a long period – although not during the most dynamic period of a bull market – if he is rigorous about applying the method,” says author John Train.

As for the hot stocks, when they take a hard hit the investor is cornered. If the stock is sold, the loss becomes permanent. The lost money cannot grow. If the investor hangs on to the deflated stock, the long trail back to the original purchase price will deeply erode the overall return.

Thursday 26 November 2009

Bubbles: From Inception to Crash (4 phases)

 
Market Bubbles
Proponents of market irrationality have pointed to market bubbles as a primary exhibit in their case against efficient markets. Through the centuries, markets have boomed and busted, and in the aftermath of every bust, irrational investors have been blamed for the crash. As we will see in this section, it is not that simple. You can have bubbles in markets with only rational investors, and assessing whether a bubble is due to irrational investors is significantly more difficult than it looks from the outside.

 
A Short History of Bubbles
As long as there have been markets, there have been bubbles. Two of the earliest bubbles to be chronicled occurred in the 1600s in Europe. One was the amazing boom in prices of tulip bulbs in Holland that began in 1634. A single Tulip bulb (Semper Augustus was one variety) sold for more than 5000 guilders (the equivalent of more than $ 60000 today) at the peak of the market. Stories abound, though many of them may have been concocted after the fact, of investors selling their houses and investing the money in tulip bulbs. As new investors entered the market in 1636, the frenzy pushed up bulb prices even more until the price peaked in early February. Figure 7.11 presents the price of one type of bulb (Switzers) in January and February of 1637.[1]

 

 
Note that the price peaked on February 5, 1637, but an investor who bought tulip bulbs at the beginning of the year would have seen his or her investment increase almost 30 fold over the next few weeks.

 
A little later in England, a far more conventional bubble was created in securities of a firm called the South Seas Corporation, a firm with no assets that claimed to have the license to mint untold riches in the South Seas. The stock price was bid up over the years before the price plummeted. The crash, which is described in vivid detail in Charles Mackay�s classic book titled �Extraordinary Delusions and the Popular Madness of Crowds�, left many investors in England poorer.[2]

 
Through the 1800s, there were several episodes of boom and bust in the financial markets in the United States and many of these were accompanied by banking panics.[3] As markets became broader and more liquid in the 1900s, there was a renewed hope that liquidity and more savvy investors would make bubbles a phenomenon of the past, but it was not to be. In 1907, J.P. Morgan had to intervene in financial markets to prevent panic selling, a feat that made his reputation as the financier of the world. The 1920s saw a sustained boom in U.S. equities and this boom was fed by a number of intermediaries ranging from stockbrokers to commercial banks and sustained by lax regulation. The crash of 1929 precipitated the great depression, and created perhaps the largest raft of regulatory changes in the United States, ranging from restrictions on banks (the Glass-Steagall Act) to the creation of a Securities Exchange Commission.

 
The period after the second world war ushered in a long period of stability for the United States, and while there was an extended period of stock market malaise in the 1970s, the bubbles in asset prices tended to be tame relative to past crashes. In emerging markets, though, bubbles continued to form and burst. In the late 1970s, speculation and attempts by some in the United States to corner the precious metals markets did create a brief boom and bust in gold and silver prices. By the mid-1980s, there were some investors who were willing to consign market bubbles to history. On October 19, 1987, the U.S. equities market lost more than 20% of their value in one day, the worst single day in market history, suggesting that investors, notwithstanding technological improvements and more liquidity, still shared a great deal with their counterparts in the 1600s. In the 1990s, we witnessed the latest in this cycle of market bubbles in the dramatic rise and fall of the �dot-com� sector. New technology companies with limited revenues and large operating losses went public at staggering prices (given their fundamentals) and kept increasing. After peaking with a market value of $ 1.4 trillion in early 2000, this market too ran out of steam and lost almost all of this value in the subsequent year or two. Figure 7.12 summarizes the Internet index and the NASDAQ from 1994 to 2001:

 

 
The chart again has the makings of a bubble, as the value of the index internet index increased almost ten fold over the period, dragging the tech-heavy NASDAQ up with it.

 
Rational Bubbles?
A rational bubble sounds like an oxymoron, but it is well within the realms of possibility. Perhaps the simplest way to think of a rational bubble is to consider a series of coin tosses, with a head indicating a plus day and a tail a minus day. You would conceivably get a series of plus days pushing the stock price above the fair value, and the eventual correction is nothing more than a reversion back to a reasonable value. Note too that it is difficult to tell a bubble from a blunder. Investors in making their assessments for the future can make mistakes in pricing individual assets, either because they have poor information or because the actual outcomes (in terms of growth and returns) do not match expected values. If this is the case, you would expect to see a surge in prices followed by an adjustment to a fair value. In fact, consider what happened to gold prices in the late 1970s. As inflation increased, many investors assumed (incorrectly in hindsight) that high inflation was here to stay and pushed up gold prices accordingly. Figure 7.13, which graphs gold prices from 1970 to 1986, looks very much like a classic bubble, but may just indicate our tendencies to look at things in the rear view mirror, after they happen.


 
Note that the surge in gold prices closely followed the increase in inflation in the late 1970s, reflecting its value as a hedge against inflation. As inflation declined in the 1980s, gold prices followed. It is an open question, therefore, whether this should be even considered a bubble.

 
Bubble or Blunder: Tests
There are some researchers who argue that you can separate bubbles from blunders by looking at how prices build up over time. Santoni and Dwyer (1990), for instance, argue that you need positive two elements for a bubble �
  • positive serial correlation in returns and
  • a delinking of prices and fundamentals as the bubble forms.
They test the periods prior to 1929 and 1987 crashes to examine whether there is evidence of bubbles forming in those periods. Based upon their analysis, there is no evidence of positive serial correlation in returns or of a reduction in the correlation between prices and fundamentals (which they define as dividends) in either period. Therefore, they argue that neither period can be used as an example of a bubble.

 
While there is truth to the underlying premise, these tests may be too weak to capture bubbles that form over long periods. For instance, Santoni and Dwyer�s conclusion of no serial correlation seems to be sensitive to both the time periods examined and the return interval used. In addition, detecting a delinking of prices and fundamentals statistically may be difficult to do if it happens gradually over time. In short, these may be useful indicators but they are not conclusive.

 
Bubbles: From Inception to Crash
One or the more fascinating questions in economics examines how and why bubbles form and what precipitates their bursting. While each bubble has its own characteristics, there seem to four phases to every bubble.

 
Phase 1: The Birth of the Bubble
Most bubbles have their genesis in a kernel of truth. In other words, at the heart of most bubbles is a perfectly sensible story. Consider, for instance, the dot.com bubble. At its center was a reasonable argument that as more and more individuals and businesses gained online access, they would also be buying more goods and services online. The bubble builds as the market provides positive reinforcement to some investors and businesses for irrational or ill-thought out actions. Using the dot.com phenomenon again, you could point to the numerous start-up companies with half-baked ideas for e-commerce that were able to go public with untenable market capitalizations and the investors who made profits along the way.

 
A critical component of bubbles building is the propagation of the news of the success to other investors in the market, who on hearing the news, also try to partake in the bubble. In the process, they push prices up and provide even more success stories that can be used to attract more investors, thus providing the basis for a self-fulfilling prophecy. In the days of the tulip bulb craze, this would have had to be word of mouth, as successful investors spread the word, with the success being exaggerated in each retelling of the story. Even in this century, until very recently, the news of the success would have reached investors through newspapers, financial newsmagazines and the occasional business show on television. In the dot.com bubble, we saw two additional phenomena that allowed news and rumors to spread even more quickly. The first was the internet itself, where chat rooms and web sites allowed investors to tell their success stories (or make them up as they went along). The second was the creation of cable stations such as CNBC, where analysts and money managers could present their views to millions of investors.

 
Phase 2: The Sustenance of the Bubble
Once a bubble forms, it needs sustenance. Part of the sustenance is provided by the institutional parasites that make money of the bubble and develop vested interests in preserving and expanding the bubbles. Among these parasites, you could include:

 
Investment banks: Bubbles in financial markets bring with them a number of benefits to investment banks, starting with a surge in initial public offerings of firms but expanding to include further security issues and restructurings on the part of established firms that do not want to be shut out of the party.
Brokers and analysts: A bubble generates opportunities for brokers and analysts selling assets related to the bubble. In fact, the ease with which investors make money as asset prices go up, often with no substantial reason, relegates analysis to the backburner.
Portfolio Managers: As a bubble forms, portfolio managers initially watch in disdain as investors they view as naive push up asset prices. At some point, though,, even the most prudent of portfolio managers seem to get caught up in the craze and partake of the bubble, partly out of greed and partly out of fear.
Media: Bubbles make for exciting business news and avid investors. While this is especially noticeable in the dot.com bubble, with new books, television shows and magazines directly aimed at investors in these stocks, even the earliest bubbles had their own versions of CNBC.
In addition to the institutional support that is provided for bubbles to grow, intellectual support is usually also forthcoming. There are both academics and practitioners who argue, when confronted with evidence of over pricing, that the old rules no longer apply. New paradigms are presented justifying the high prices, and those who disagree are disparaged as old fashioned and out of step with reality.

 
Phase 3: The Bursting of the Bubble
All bubbles eventually burst, though there seems to be no single precipitating event that causes the reassessment. Instead, there is a confluence of factors that seem to lead to the price implosion.
  • The first is that bubbles need ever more new investors (or at least new investment money) flowing in for sustenance. At some point, you run out of suckers as the investors who are the best targets for the sales pitch become fully invested.
  • The second is that each new entrant into the bubble is more outrageous than the previous one.
Consider, for instance, the dot.com bubble. While the initial entrants like America Online and even Amazon.com might have had a possibility of reaching their stated goals, the new dot.com companies that were listed in the late 1990s were often idea companies with no vision of how to generate commercial success. As these new firms flood the market, even those who are apologists for high prices find themselves exhausted trying to explain the unexplainable.

 
The first hint of doubt among the true believers turns quickly to panic as reality sets in. Well devised exit strategies break down as everyone heads for the exit doors at the same time. The same forces that created the bubble cause its demise and the speed and magnitude of the crash mirror the formation of the bubble in the first place.

 
Phase 4: The Aftermath
In the aftermath of the bursting of the bubble, you initially find investors in complete denial. In fact, one of the amazing features of post-bubble markets is the difficulty of finding investors who lost money in the bubble. Investors either claim that they were one of the prudent ones who never invested in the bubble in the first place or that they were one of the smart ones who saw the correction coming and got out in time.

 
As time passes and the investment losses from the bursting of the bubble become too large to ignore, the search for scapegoats begins. Investors point fingers at brokers, investment banks and the intellectuals who nurtured the bubble, arguing that they were mislead.

 
Finally, investors draw lessons that they swear they will adhere to from this point on. �I will never invest in a tulip bulb again� or �I will never invest in a dot.com company again� becomes the refrain you hear. Given these resolutions, you may wonder why price bubbles show up over and over. The reason is simple. No two bubbles look alike. Thus, investors, wary about repeating past mistakes, make new ones, which in turn create new bubbles in new asset classes.

 
Upside versus Downside bubbles
Note that most investors think of bubbles in terms of asset prices rising well above fair value and then crashing. In fact, all of the bubbles we have referenced from the tulip bulb craze to the dot-com phenomenon were upside bubbles. But can asset prices fall well below fair market value and keep falling? In other words, can you have bubbles on the downside? In theory, there is no reason why you could not, and this makes the absence of downside bubbles, at least in the popular literature, surprising. One reason may be that investors are more likely to blame external forces � the bubble, for instance � for the money they lose when they buy assets at the peak of an upside bubble and more likely to claim the returns they make when they buy stocks when they are at the bottom of a downside bubble as evidence of their investment prowess.

 
Another may be that it is far easier to create investment strategies to take advantage of under priced assets (in a downside bubble) than it is to take advantage of over priced assets. With the former, you can always buy the asset and hold until the market rebounds. With the latter, your choices are both more limited and more likely to be time limited. You can borrow the asset and sell it (short the asset), but not for as long as you want � most short selling is for a few months. If there are options traded on the asset, you may be able to buy puts on the asset though, until recently, only of a few months duration. In fact, there is a regulatory bias in most markets against such investors who are often likely to be categorized as speculators. As a consequence of these restrictions on betting against overpriced assets, bubbles on the upside are more likely to persist and become bigger over time, whereas bargain hunters operate as a floor for downside bubbles.

 
A Closing Assessment
Based upon our reading of history, it seems reasonable to conclude that there are bubbles in asset prices, though only some of them can be attributed to market irrationality. Whether investors can take advantage of bubbles to make money seems to be a more difficult question to answer. Part of the reason for the failure to exploit bubbles seems to stem from greed �even investors who believe that assets are over priced want to make money of the bubble � and part of the reason is the difficulty of determining when a bubble will burst. Over valued assets may get even more over valued and these overvaluations can stretch over years, thus imperiling the financial well being of any investor who has bet against the bubble. There is also an institutional interest on the part of investment banks, the media and portfolio managers, all of whom feed of the bubble, to perpetuate the bubble.