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.

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.

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

Definition of a Stock Bubble

Definition of a stock bubble


A bubble occurs in a stock when:

1.  Implausible assumptions are applied to justify its present price using normal valuation (e.g.  DCF) models.

2.  There are people buying at these prices ignoring these implausible assumptions.


Based on this defintition, Tesla is a bubble while Apple and Microsoft are not at current prices.  

Buffett: Measured against interest rates, stocks are actually on the cheap side compared to historic valuations.

BUFFETT ON BONDS

WHEN RATES HAVE BEEN WHERE THEY HAVE BEEN THE LAST FIVE OR SIX YEARS OR EVEN LONGER, SELLING VERY LONG BONDS MAKES SENSE FOR THE SAME REASON I THINK IT'S DUMB TO BUY THEM. I WOULDN'T BUY 50 YEAR BOND IN A MILLION YEARS AT THESE RATES IF IT'S THAT DUMB FOR ME TO BUY IT, ITS PROBABLY PRETTY SMART FOR THE ENTITY TO SELL THEM. IF I AM RIGHT. SO I WOULD SAY THE TREASURY – THERE'S A LOT OF CONSIDERATIONS THEY HAVE, BUT I WOULD BE SHOVING OUT LONG BONDS.

BUFFETT ON BUYING CONSISTENTLY

THE BEST THING WITH STOCKS ACTUALLY IS TO BUY THEM CONSISTENTLY OVER TIME. YOU WANT TO SPREAD THE RISK AS FAR AS THE SPECIFIC COMPANIES YOU'RE IN BY OWNING A DIVERSIFIED GROUP AND YOU DIVERSIFY OVER TIME. BY BUYING THIS MONTH, NEXT MONTH, THE YEAR AFTER, THE YEAR AFTER, THE YEAR AFTER. YOU'RE MAKING A TERRIBLE MISTAKE IF YOU STAY OUT OF A GAME YOU THINK IS GOING TO BE VERY GOOD OVER TIME BECAUSE YOU THINK YOU CAN PICK A BETTER TIME TO ENTER IT.

BUFFETT ON NO BUBBLE

AND WE ARE NOT IN A BUBBLE TERRITORY. OR ANYTHING OF THE SORT. IF INTEREST RATES WERE 7 OR 8%, THEN THESE PRICES WOULD LOOK EXCEPTIONALLY HIGH. BUT YOU HAVE TO MEASURE – YOU MEASURE EVERYTHING AGAINST INTEREST RATES BASICALLY. AND INTEREST RATES ACT LIKE GRAVITY ON VALUATION.

BUFFETT ON STOCKS CHEAP

MEASURED AGAINST INTEREST RATES, STOCKS ACTUALLY ARE ON THE CHEAP SIDE COMPARED TO HISTORIC VALUATIONS. BUT THE RISK ALWAYS IS THAT INTEREST RATES GO UP A LOT AND THAT BRINGS STOCKS DOWN. BUT I WOULD SAY THIS, IF THE TEN YEAR STAYS AT 230 AND WOULD STAY THERE FOR 10 YEARS, YOU WOULD REGRET VERY MUCH NOT HAVING BOUGHT STOCKS NOW.

http://www.cnbc.com/2017/02/27/cnbc-excerpts-billionaire-investor-warren-buffett-speaks-with-cnbcs-becky-quick-on-squawk-box-today.html

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

Stock market bubbles - A brief history

“Money, again, has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper.”

- Charles Mackay, Extraordinary Popular Delusions And The Madness Of Crowds, 1841.

Economic bubbles are great examples of societies failing to learn from previous mistakes. Time and time again something comes along that seems too good to be true and it inevitably turns out that it is. People invest in their masses and the more who invest, the higher the price rises, drawing more people in until eventually the bottom falls out and people lose a lot, sometimes everything.

Bubbles in nature are simple, perfect and beautiful. Investment bubbles can seem the same way at the beginning – perfect and so beautifully simple. You put money in and it grows, what could be easier or more rewarding than that? Nature’s bubbles are incredibly delicate though and are all destined to eventually pop, gone forever. Economic bubbles are the same, but it takes a while for people to see how fragile they are, often not before it is too late.

Outlined below are 4 major bubbles from the past 400 years, taking in bubbles surrounding individual companies, whole industries and entire national economies.

Tulip Mania

One of the earliest examples of a bubble occurred in the Dutch Republic in the 1630s. It concerned the trade of tulip bulbs, or more specifically the trade of agreements to buy tulip bulbs, essentially what we would refer to as futures contracts today.

Tulips flower in mid-Spring, with their bulbs becoming dormant and ready for harvesting around June. The bulbs stay dormant until September, after which they must be planted. This meant that the sale of bulbs could only occur between June and September, with agreements to buy bulbs (rather than the bulbs themselves) changing hands the rest of the year.

New varieties of stripy petalled tulips started to appear in the early 1630s and as they popularity grew speculators started to move in. By 1636 contracts for single bulbs were changing hands for many multiples of average yearly salaries, with some contracts changing hands dozens of times a day. Many people made huge fortunes having never even laid eyes on the tulip bulbs their agreements were backed by.

Trade was not confined to financiers and bankers, many regular people were drawn into the whirlwind of sky-rocketing prices, believing that the rich from all over the world would soon be coming to Holland to pay huge sums for tulips and that demand would never cease.

Bulb prices peaked in February 1637 with reports of a single bulb being purchased for 100,000 (florins the equivalent of around £1million in today’s money) then dipped suddenly, after which trading quickly ground to a halt, financially ruining huge numbers of people.

It’s worth noting that short selling was a practice banned in the Dutch Republic at the time, making it very hard for investors to re-coup any losses as the tulip prices started their inexorable decline.

The South Sea Bubble

Around 75 years later, in 1711, the South Sea Company was founded in Britain, ostensibly as a monopolistic trading company for commerce with South America. The company never did much trade in that regard though due to the Spain’s grip on the continent and the ongoing War of Spanish Succession. Instead, the company was used as a vehicle for consolidating Britain’s national debt. Those whom the nation owed a monetary debt were given shares of equal value in the newly formed company with a dividend (paid by the government, rather than the company).

This resulted in potentially lower returns for the holders of the relatively risk free national debt, but turned an illiquid market liquid, allowing the debt to be freely traded as shares.

In 1719 a scheme was hatched for the South Sea Company to take on moregovernment debt in return for shares, around £2.5million worth. Such was the success of this refinancing that the government decided to repeat the process, hoping to pass over most of the national debt, approximately £31million.

After this, in early 1720, the already bloated company set about putting rumours about of the potential riches to be gathered in South America using their monopoly. The speculators dove straight in, boosting the share price from £120 to £550 by May. The company itself started lending money to speculators to buy shares in order to artificially inflate the price. By early August the share price had nearly hit £1,000 and it came time for the company to reclaim the money it had lent.

Many speculators were only able to pay back their debts by selling their South Sea shares, causing a sudden drop in the share price. Many investors who had bought near the top on credit were now sorely out of pocket, forcing them to sell their holdings for a loss and forcing the price down even further. By the end of the year the share price had fallen to £100 with many investors bankrupt or nursing serious dents to their fortunes.

Wall Street Crash

As the 1920s drew to a close in the USA the Great Depression was kicked off by the largest stock market crash in US history. The Dow Jones Industrial Average peaked at just over 381 points on 3 September 1929, but by 13 November had hit 198, a fall of 42%. By 8 July 1932 the Dow had slipped down to just above 41 points, a slide of over 91% from its high. What happened?

As with the two examples outlined above, the bursting of the bubble was preceded by rife speculation, first by financial professionals, but soon by an increasing proportion of the general populace.

Technological advances created new products, companies and industries in the 1920s and generated a mood of optimism. Many Americans became stockholders who had previously never dabbled in the markets. As prices started to rise and paper profits rose accordingly many borrowed money to invest in shares or took on large margins to maximise profit. At one point more money has been loaned for purchasing shares than there was hard currency in the country, over $8billion.

Panic selling started on Black Thursday, 24 October 1929, with the ow dropping 11% in one day. This was followed by two further major falls, 13% on 28 October and 12% on 29 October. Margin calls came in and speculators, both financiers and private individuals lost huge sums of money.

The Dot Com Bubble

An entirely new industry sprang up in the late 1990s consisting of companies focussed on the internet, collectively known as dot coms. In a strange twist to the standard bubble arc, investors were seemingly unfazed by the lack of profit these companies showed, in fact some companies would go to initial public offering having only ever made large losses.

A large number of these companies were focussed on rapid growth in the new industry, putting profits as a secondary requirement to be fulfilled further down the line. The mantra of the day was “get large or get lost”. investors bought into this in a way that would unlikely ever have done in other, more established industries. As with the examples above, the speculators moved in and share prices began to rise and rise.

The US Federal Reserve increased interest rates significantly between mid 1999 and early 2000 causing the US economy to slow down. In turn, dot com share prices began to falter. Many companies were listed on the NASDAQ Composite which peaked at 5,048.62 on 10 March 2000 falling to only 1,114.11 on 9 October 2002.

Future bubbles

History has shown us the same pattern repeated in each of the bubbles above. New ideas creating initial optimism and wealth but turning to depression and severe hardship as things get out of control. Doubtless this pattern will be repeated again in the future, probably many times.

It is often hard to see the signs of a bubble until it is too late, but if you take a step back and look at recent developments in new ideas like Bitcoin, or the seemingly endless rise in London house prices you might see certain correlations. Keep an eye out and invest wisely.

“In the present state of civilization, society has often shown itself very prone to run a career of folly from the last-mentioned cases. This infatuation has seized upon whole nations in a most extraordinary manner.” - Charles Mackay, 1841

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How Britain’s greatest physicist lost a fortune

How (not) to invest like Sir Isaac Newton

How does George Soros dealt with asset bubbles?

“When I see a bubble forming I rush in to buy,” he said. In January 2010 he declared gold to be the “ultimate asset bubble” shortly after he built up a £400m stake in the metal.

He had sold most of it by March 2011, at a handsome profit – and comfortably before the bubble popped in September of that year.

Not everyone can pull off the same trick; some clever people have lost a lot of money by failing to get out before everyone else. Some very clever people indeed, actually: one investor who lost a fortune this way was Britain’s greatest physicist, Sir Isaac Newton.

Newton was a victim of the South Sea Bubble, one of the most famous boom-and-busts in history – in fact, it was the one that gave rise to the very term “bubble”.

As the graph above shows, he initially did just what Mr Soros would do centuries later – invest early and then sell after making excellent returns very quickly. But Newton made the mistake of re-entering the market much closer to the peak, and then hanging on even after the bubble had burst, selling only once the price had collapsed to well below his buying price.

Newton reportedly lost £20,000, equivalent to about £3m in today’s terms.

The South Sea Company was an unusual business. Founded in 1711, it was promised a monopoly on trade with Spanish South American colonies by the British government in exchange for taking over the national debt raised by the War of Spanish Succession. However, the trade concessions turned out to be less valuable than hoped.

In January 1720, when the company’s shares stood at £128, the directors circulated false claims of success and fanciful tales of South Sea riches and in February the shares rose to £175.

The following month the company convinced the government to allow it to assume more of the national debt in exchange for its shares, beating a rival proposal from the Bank of England. With investor confidence mounting, the share price had climbed to about £330 by the end of March.

The South Sea Company was part of a wider flurry of speculation on the stock market, however.

Newly floated firms were seen as appearing like bubbles; 1720 was sometimes known as the “bubble year”. In June, Parliament, at the behest of the South Sea Company, passed the Bubble Act, which required all shareholder-owned companies to receive a royal charter.

The South Sea Company received its charter, perceived as a vote of confidence in the company, and at the end of June its share price reached £1,050.

But investors started to lose confidence in early July and by September the shares had plummeted to £175, devastating investors.

How to avoid losing a fortune in bubbles

The simplest way to avoid losing money in a bubble is not to invest in any asset in which you suspect a bubble is forming. But as the example of Newton illustrates, this can be easier said than done. The temptation to join in, especially if you tell yourself that you will “sell before the bubble bursts”, can be irresistible.

If you do buy into the latest hot investment, one homespun piece of advice is to sell when even the taxi drivers are talking about it. 

http://www.telegraph.co.uk/finance/personalfinance/investing/10848995/How-not-to-invest-like-Sir-Isaac-Newton.html

Equity Risk Premium: Stock bubble? No way, says Alan Greenspan

Stock bubble? No way, says Alan Greenspan

Former Federal Reserve chairman Alan Greenspan says the stock market has room to rise from record levels.

“In a sense, we are actually at relatively low stock prices,” Mr Greenspan, who guided the central bank for more than 18 years, told Bloomberg Television overnight. “So-called equity premiums are still at a very high level, and that means that the momentum of the market is still ultimately up.”

The Standard & Poor’s 500 Index advanced 23 per cent this year through yesterday, pulling within a percentage point of its 23.5 per cent surge in 2009, amid speculation the Fed will delay cuts to its monthly bond purchases until the labour market improves.

Mr Greenspan said the stock market was “just barely above 2007” and the average annual increase in stock prices “throughout the postwar period” was 7 per cent, which leaves room for a rise.

“Price-earnings ratios are not hugely up,” he said. The market has “gone up a huge amount, but it’s not bubbly,” according to Mr Greenspan.

Mr Greenspan, 87, served at the Fed during an era dubbed the “Great Moderation” for its economic stability. In a December 1996 speech, after seven straight quarters of gains in the S&P 500, Mr Greenspan posed a question about how the Fed can know “when irrational exuberance has unduly escalated asset values.”

In the final years of Greenspan’s term, which lasted from 1987 to 2006, a massive housing bubble developed as home prices more than doubled between 2000 and 2006, according to the S&P/Case-Shiller home price index.
Mr Greenspan said today’s housing market doesn’t show the same conditions as it exhibited leading up to the housing crash, and is lending stability to the US economy.

“The level of construction has come up quite substantially, but it’s still only a third of where we were at the previous top,” Mr Greenspan said. “While housing has been a major contributor to what stability we have in the economy, it has not moved considerably.”

Purchases of new US homes rose in August, capping the weakest two months this year, showing the fallout from mortgage rates at a two-year high is cooling the real-estate rebound. Sales increased 7.9 per cent to a 421,000 annualised pace following a 390,000 rate in the prior month that was less than previously estimated, Commerce Department data showed September 25.


Mr Greenspan also praised Fed vice-chairman Janet Yellen, whom President Barack Obama has nominated as the next head of the central bank, both in the Bloomberg interview and in an earlier interview on CNBC.

“She’s a very bright lady,” Mr Greenspan said of Ms Yellen on CNBC. “I think she will surprise everybody, I mean in a positive way.”

Bloomberg


Read more: http://www.smh.com.au/business/markets/stock-bubble-no-way-says-alan-greenspan-20131024-2w2ky.html#ixzz2ih57UwLr


Related:

Equity valuations relative to bond market
http://myinvestingnotes.blogspot.com/2010/07/equity-valuation-s-500-relative-to-bond.html

When is the market over-valued?
http://myinvestingnotes.blogspot.com/2009/07/when-is-market-over-valued.html

Effects of a stock market bubble on the markets and on the broader economy.

Effects of a bubble on the markets are obvious.

1.  On the way up, investors become too confident about their anticipated returns.

2.  Money floods in - part of the definition of a bubble - and prices rise to even more unrealistic levels.

3.  At some point, air starts to come out of the bubble.

4.  Share prices drop and some investors, including pension plans and other institutional holders, lose a lot of money.

5.  Many equity investors feel burned and move out of the stock market for good, and it takes years for new ones to take their place.

6.  The consequence of a bubble for markets, then, is to reward winners and punish losers with a savage intensity.  


The influence of a bubble market on the broader economy maybe even more long lasting and more perverse.  Here are some of the more important consequences of the technology bubble of 2000 in the U.S.:

1.  Excessive investment in telecommunications and related industries, thanks to the funds available from stock offerings and borrowings that the bubble market made possible.

2.  Expansion to the point of collapse, or near-collapse, by companies that were profitable but used the high price of their shares to make foolish acquisitions or increase capacity beyond what a sensible view of the future would have allowed.

3.  Incompetent, dishonest, and fraudulent behaviour by corporate executives, boards of directors, auditors, investment bankers, security analysts, and other market participants.


Conclusion:

Competitive market economies have always been subject to business cycles.

Like all cycles, they are painful on the way down.

A wider acceptance of the principles of value investing may ease some of that pain the next time the mania sets in.

Extraordinary Popular Delusions And The Madness Of Markets

The twin bubbles of today: Government bonds (which are set to burst) and gold (which is getting ready to enter the mania phase).

Warren Buffett on Bubbles and Excess Leverage

http://www.youtube.com/watch?v=X37cv_Q0jnY&list=UUeC5fFyQB62lnEPlDMWCoXw&index=4&feature=plcp

Market Mania Montage - A New Mania coming to Market near You SOON

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

Just How Smart Is Wall Street?

 Posted: August 12, 2011 1:48PM by Stephen D. Simpson, CFA

Individual investors see a steady stream of paeans to Wall Street, praising not only the substantial resources of professional investors, but also suggesting (sometimes subtly, sometimes not) that these professionals are smarter and more capable than the average investor. While there are certainly plenty of columns out there decrying the mistakes of professional investors and pointing out that disciplined individuals can do just as well, the fact remains that the financial media overwhelmingly tilts towards the idea that Wall Street is smarter than you or me.

TUTORIAL: World's Greatest Investors

But is it really? The word "smart" has plenty of definitions, but Wall Street has such a peculiar inability to learn from certain mistakes that it seems worthwhile to question just how smart the Street really is.

They Can't Stay Away From the BubblesNothing of any real size can happen in the investment world without the involvement of institutional investors. So while retail investors are often dismissed as the "dumb" money, it is the professionals who ultimately add the most air to investment bubbles.

It was professionals, not individual investors, who awarded absurd IPO valuations to stocks like TheGlobe.Com, Geocities or eToys.com. Professional investors were also apparently happy to pay upwards of 30 times sales for Cisco (Nasdaq:CSCO), Qualcomm (Nasdaq:QCOM) and JDS Uniphase (Nasdaq:JDSU) back in the bubble days.

Only a few years later, institutions happily dove into the housing bubble. Institutions apparently were not bothered by data that clearly showed affordability was declining at a precipitous rate and that lending standards were abysmally low. In fact, institutions got so casual about the bubble that they happily relied upon models that told them housing prices could never fall - even though there were plenty of examples from outside the U.S. that showed what could happen.

These are only two examples of how the institutional community is all too happy to believe "it's different this time" and "prices couldn't possibly fall from here." The fact is, that the Street is happy to play a game of musical chairs because the players almost always believe they'll find a seat before the music stops … even if years of history suggests otherwise. (Home price appreciation is not assured. For more, see Why Housing Market Bubbles Pop.)

A Few Gaps in Their Due DiligenceAlthough plenty of institutional investors now claim to have spotted the shenanigans at Enron and Worldcom and shorted the stocks, those stocks would have deflated much sooner if all of these people were telling the truth. The fact is, plenty of institutions lost huge amounts of money in names like Enron, Worldcom, CUC/Cendant, Waste Management and so on, when their accounting scandals finally became unsupportable. In fact, when Enron blew up, well-regarded names like Alliance Capital Management, Janus, Putnam, Barclays and Fidelity owned about 20% of the stock in total, and most major firms held some number of shares.

Even in the wake of scandal after scandal, institutions have apparently not filled all the gaps in their due diligence. During the housing bubble and crash, institutions were largely blind to the balance sheet time bombs of financial companies like Washington Mutual and AIG (NYSE:AIG), to say nothing of their off-balance sheet liabilities. Even in the last few months, John Paulson reportedly lost millions of dollars on his position in Sino-Forest when evidence finally arose that the company may have grossly overstated its asset base. Likewise, plenty of other smart money investors have gotten caught up in other Chinese debacles. (For more, see Hedge Fund Due Diligence.)

Overconfidence, Especially in Their Own ModelsHowever smart Wall Street professionals are, it doesn't shield them from overconfidence in their abilities and their models. Time and time again some sharp-eyed professionals will spot a profitable anomaly in the markets - junk bonds or Latin American sovereign bonds that price in too much risk of default, undervalued mortgage bonds, unexploited absolute return strategies and so on. In the early days, there are in fact plenty of great opportunities, but eventually word gets out, other investors try to replicate the strategy and investment bankers rush to fill the supply of look-alike products.

The list of well-known implosions goes on and on - from the heyday of junk bond-fueled LBOs to the numerous emerging market sovereign debt debacles to the "see no evil" models of the U.S. housing market. In almost every case, though, the fundamentals change, the experts fail to notice, more leverage gets poured into the process and it all blows up in everyone's collective face.

The case of Long Term Capital Management (LTCM), though a 13-year-old story now, is still a great example. Mixing very experienced and successful Wall Street professionals with a small army of PhDs, LTCM used very high amounts of leverage to exploit small inefficiencies in the market. Unfortunately, early success brought more capital into the firm than it could manage, more leverage was employed to squeeze bigger returns out of smaller anomalies, and then suddenly some of the key relationships underpinning its models fell apart. The end result was a spectacular failure - one so large that the federal government stepped in to help the unwinding process from destabilizing the financial markets.

TUTORIAL: Credit Crisis: Historical Crises

The Bottom LineThese are just a few brief examples of the "factory seconds" that Wall Street churns out with surprising regularity. What of the fact that Wall Street routinely puts its faith in the projections and promises of management teams with no record of competence or success? Or what of the fact that Wall Street professionals routinely trust their investors capital with people and instruments that have previously failed?

The fact is, Wall Street is made up of people and people (even well-trained and well-compensated examples) make mistakes. Whether its greed, overconfidence or a sincere belief that it is somehow different this time, Wall Street cannot resist taking a chance on money-making opportunities. The point here is not to bury Wall Street or excoriate its professionals for their mistakes. Rather, the point is that everybody makes mistakes and investors should never be intimated out of their own good judgment and common sense just because the "smart money" thinks differently. (For more on smart money, see On-Balance Volume: The Way To Smart Money.) 

Read more: http://financialedge.investopedia.com/financial-edge/0811/Just-How-Smart-Is-Wall-Street.aspx#ixzz1VKT47J00

How to forecast a stock-market top

4/19/2011 2:43 PM ET.
By Mark Hulbert, MarketWatch.

How to forecast a stock-market top

A Wall Street research firm is tracking four key indicators for signs that the bull market is on its last legs. Here's what to look for.


How will we know when the bull market is coming to an end?

This is a timely question, given the extraordinary crosscurrents buffeting the market. Some advisers contend that the bull is alive and well, while others assert that the bull is living on borrowed time.

For insight, I turned to Ned Davis Research, the quantitative research firm, which monitors a basket of indicators to help determine when a market top is imminent.

Nearly two years ago I turned to the company for help in answering this very question. At the time, many were convinced the rally was but a bear-market correction. But Ned Davis, upon analyzing various indicators of a potential top, concluded that the bull market had further to go.

What does Davis' firm say now?

Ed Clissold, the global equity strategist at the company, said there are worrisome signs on the horizon, but the company is giving the bull the benefit of the doubt.

In assessing when the bull might end, Clissold said, the company has identified four major categories:


Valuation
Though stock valuations aren't at such an extreme as to cause this category of indicators to flash a sell signal, there are causes for concern, Clissold said.

One of these, according to a letter Ned Davis sent last week to institutional clients, is that "profit margins on the S&P are at record highs. . . . Using data back to 1954, very high profit margins, on average, have not been bullish for stocks, because the series is very mean-reverting."

Davis also was concerned with the cyclically adjusted P/E ratio made famous by Yale professor Robert Shiller.

At the same time, however, Clissold referred to other valuation measures that suggest stocks are not particularly expensive, such as the P/E ratio based on 12-month earnings (as opposed to the 10-year average Shiller prefers).

All in all, a split decision on valuation. As Davis wrote earlier this week: "I can certainly understand the bullish stance of those who argue stocks are still reasonably priced, based upon current earnings. Yet, I don't think that presents a complete picture of potential risks. I am just providing the evidence for clients to make their own decisions."

Sentiment
This is the one category of the four that, in Davis' opinion, comes closest to yelling "sell."

Davis maintains two sentiment indices, one of which is well into the zone of excessive optimism; the other borders on that zone.

On contrarian grounds, that is worrisome.

Market breadth
This category is perhaps the most bullish, according to Davis.

"One of the key characteristics of a major top in the stock market is considerable divergences," Davis wrote, and there are few signs of that.

Davis tracks the "High Low Logic Index," which represents the lesser of new 52-week highs or new 52-week lows as a percentage of all issues traded. The index traces its roots to a metric created three decades ago by Norman Fosback.

In his book "Stock Market Logic," Fosback describes the rationale behind the metric: "Under normal conditions, either a substantial number of stocks establish new annual highs or a large number set new lows -- but not both.

"As the (High Low) Logic Index is the lesser of the two percentages, high readings are therefore difficult to achieve," Fosback continued. "When the Index attains a high level, it indicates that the market is undergoing a period of extreme divergence. . . . Such divergence is not usually conducive to future rising stock prices."

Currently, according to Davis, the index is bullish, at 2.4%. At the stock market top prior to the 2007-2009 bear market, it rose to close to 6%. The only other time in recent decades the index got this high was in early 2000, right before the popping of the Internet bubble.

Interest rates
This category, like valuation, is providing some causes for concern, according to Clissold, but is not yet bearish.

The concerns derive from higher rates, which have caused some of the firm's interest-rate-trend indicators to enter bearish territory. However, Clissold said he doesn't think that these concerns yet amount to a "screaming sell signal."

One straw in the wind to look out for, he said, is the 10-year Treasury yield rising to around 4.25% -- three quarters of a percentage point above its current level.

Summing up the situation
The bottom line, according to Davis?

"There are a number of things about this market that concern me as a risk manager," he said. Still, all things considered, for now, he "leans bullish."

Warren Buffett on Bubbles and Excess Leverage

http://youtu.be/X37cv_Q0jnY