Stock markets flirt with full bubble territory

Stock markets flirt with full bubble territory
With the FTSE 100 back at levels last seen before the collapse of Lehman Brothers, Martin Hutchinson asks whether there is a bubble brewing in asset prices.

Published: 11:36AM GMT 29 Dec 2009

Rapid increases in the prices of financial assets can be a healthy sign. Markets are doing their job when prices jump because of sudden economic strength or a disruption of supply. But when the causes are more monetary than real, a market bubble is forming. Are markets healthy or unhealthy now?

Observers from the Bank of International Settlements to the Hong Kong central bank are asking the question. And quite right, too. The MSCI World stock price index is up 70pc since March and many commodity prices are rocketing. The Reuters-CRB Metals Index is up 74pc over the past year.

Some portion of those increases is probably healthy. Prices were lowest when the financial and economic worlds were undergoing a near-death experience. Banking systems and the economy are not exactly up and running, but the trends are more positive.

Still, some markets seem to have moved past recovery into excess. The jump in commodities, probably the most "financialised" markets in the world, comes despite ample current inventories and limited recovery in demand.

Global stock markets are in danger of hitting full bubble territory. Analysts expect global market earnings to increase by 30pc in 2010, and investors are already paying a fairly generous 14 times those expected earnings, according to Societe Generale calculations.

The case for a bubble is supported by day-to-day market behaviour -- prices often fall on good economic news. Investors seem to care less about the prospect of stronger demand than about the possibility that the authorities will tighten up financial conditions.

If past practice is any guide, the tightening will be slow in coming. Central bankers have not yet fully cast off their long-established belief that asset prices aren't relevant to their task of keeping inflation at bay, while governments find it hard to abandon the many pleasures of deficit spending.

Recent experience should teach another lesson. Financial excess leads to destabilising market crashes. More distant history suggests that monetary excess frequently leads to retail price inflation. Tighter money might make the recovery less robust over the next year or two, but would make the world safer for the next decade.

http://www.telegraph.co.uk/finance/markets/6905092/Stock-markets-flirt-with-full-bubble-territory.html

In the aftermath of the bursting of the bubble

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.

http://myinvestingnotes.blogspot.com/search/label/phases%20of%20bubble

Can investors take advantage of bubbles to make money?

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.

Bubble lessons never go out of style

Bubble lessons never go out of style, and not only are going to help you with big bubbles, or individual stock bubbles, but will focus you on which information is real and what is perception in almost all of your investing. Learn the lessons well.

With bubbles, there is an element of mystery. To cope with that, start with the first step, knowledge, and combine that with your disiciplined buy and sell strategies, since in a bubble it is likely that the beliefs of the crowd cannot be supported by real knowledge.

A considerable number of people (but not all) in the investment community regarded a wide range of technology, communications, and internet stocks as having almost unlimited demand for their products and unlimited potential - all of which assumptions proved to be incorrect. Yet the entire crowd thought in this way about many Internet companies because of incorrect and incomplete information. Emotions temporarily filled that void. A disciplined buy and sell strategy helps you control your emotion.

The other big factor in irrational behaviour comes when the crowd is deliberately fooled, so some bubbles are either accompanied by or built upon fraud or swindles. In the 2000 Internet bubble, the atmosphere of greed it created did bring out the worst in a number of executives who engaged in what proved to be criminal behaviour, either outright stealing from their companies (as executives of Tyco International and Adelphia Communications did), or engaging in accounting and financial fraud (which is what Bernie Ebbers, WorldCom's chairman was convicted of in March 2005.)

There were 3 bubbles that burst in 2000, and they wer all related to one another.

1. The first was the most obvious: the stock market bubble, which had component bubbles in Internet, telecommunications, and various technology stocks. The excitement over those took almost all other stocks into overvaluation.
2. The second was the bubble in capital spending by corporations in the great telecommunications build-out that was going to accommodate all the new traffic, create broadband access for most businesses and consumers, and handle all the new uses of the Internet. The same beliefs that caused stocks to soar were also driving this corporate capital spending, since the new information about the potential of all sorts of technologies appeared to offer great opportunities. Ultimately, the Internet has proved to be a transforming force (just as, say, the railroads, were in the nineteenth century in Europe) and is changing business and life for many people. Thus, not everything that created the mania was false, and this fact just compounded the confusion.
3. The third bubble was the overall U.S. economy, which reached peak growth rates that wer more than twice the long-term average real growth. The other two bubbles caused that to happen, so when stocks came down, lower stock values and fear caused consumers and corporations to spend less. The biggest effect on the economy was the loss of the part of corporate spending that had been directed into telecommunications, since that was an incredibly large part of the overall picture.

Bubbles have one thing in common; they are going to burst

On March 6, 2000, Larry Summers and Alan Greenspan and many of the senior executives actually waxed poetic about the productivity gains, the technologies, the confluence of our capital markets and great new technological advances, and the fact that it meant great things for our future.

Four days after that March 6, 2000 gathering, on March 10, the bubble burst and the game was over. All had changed.

It all seemed very real at the time, and the senior people in government were getting their information from the sources that had proved the most valuable and trustworthy in the past for all of us: real economic data generated by consumers and corporations, as well as the very best information that the executives running those corporations could give them. We all had seen the same things, and we all had believed.

"Trying to understand is like straining through muddy water. Be still and allow the mud to settle." Lao-Tzu

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The lessons from this bubble are important for 3 reasons.

1. First, there is the unlikely possibility that we may encounter another stock market bubble in our investing lifetime. One per lifetime seems the 'rule', but we cannot rule out anything completely.
2. Second, we do have small bubbles in the market (smaller than in 1929 and 2000) periodically. These include the one caused by a mania in blue chips (called the "Nifty Fifty") from the late 1960s into early 1973, a moderate technology stock bubble in 1983, and the overvaluation in the market before the 1987 stock market "crash."
3. Third and most important, bubbles occur in INDIVIDUAL STOCKS fairly frequently.

We have all heard the term bubble and also the term mania used over the past few years very, very frequently - when people have talked about possible bubbles:

• in real estate or housing,
• in financial instruments in foreign countries, and
• at times even in the Chinese economy,

which has had some startling growth numbers that are far above anything seen before.

Bubbles, like those from bubble gum or soap, come in all different sizes, but they all have one thing in common with each other, including the gum and the soap bubbles; they are going to burst. They are unsustainable because they are not built on enough real substance to support themselves. Thus, many bubbles develop from a mania. A mania is simply something that is more emotional than tangible or rational, so it can be thought of as irrationality.

The irrationality that leads to the inflating in price beyond what complete knowledge and good analysis would suggest can be the result of one thing or of two or more things in combination.

• The irrationality itself is not very easy to see at the beginning, since there would be no bubble if it were apparent.
• The causes start with beliefs that are exciting, but the crowd does not know what it does not know.
• Knowledge is incomplete or just wrong.

When something appears that is new, and seems to have unlimited potential and some mystery about it, that, to me, is "the big one". This has happened many times in history, as when electricity first came to the household; or with the advent of canals, railroads, and radio in the 1920s and so forth. Perceptions, not analysis, drove some of the stocks to ridiculous levels and then that bubble popped.

After the bubble bursts

After the bubble bursts, a couple of things can happen.

The first is that the country will slip into a recession. You will see reports of layoffs and falling corporate profits. The Fed will actively drop interest rates, which will, in a year or so, respark the economy. The immediate impact of lower interest rates will be an increase in car and house sales. Seeing this, investors will anticipate the revival of the economy and jump back into the market. This time, though, they will be investing in the big names -like GE and Hewlett-Packard - that have earnings. They won't chase after the once-hot bubble stocks. Those stocks are dead until they begin earning money.

If the Fed's dropping of interest rates doesn't revive the economy, the country will slip into a depression and stock prices will really go to hell. It happened in the early 1920s, and the ensuing crash made 1929 pale in comparison. If that happens, you are in a major recession/depression and the stock market will be giving companies away. Value investors, including Warren, dream of such an opportunity, while the rest of the world dreads it. That's because Warren is a selective contrarian investor with a ton of cash and a long-term perspective.

However, Warren Buffett does not buy or sell baseed on what he thinks the market will do. He is price-motivated. This means that he will only invest when the price of the company makes business sense.