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