History is littered with investment bubbles, periods when asset prices were inflated by speculation only to pop spectacularly when the mood turned.
There was the Dutch tulip mania of 1637, the South Sea Bubble of the 1720s, the Florida Land Bubble of 1926, and the Tech Bubble of the late 1990s, to name a few.
Investors could save themselves a lot of heartache — and money— by being adept at identifying a bubble before it bursts, because they can have a devastating effect on wealth. But is it possible to spot such a bubble? During his time as chairman of the Federal Reserve, Alan Greenspan argued that it was impossible to predict with any certainty until after the event.
Robin Griffiths, technical strategist at Cazenove Capital, says that bubbles tend to occur in three phases.He says that a particular market starts by being cheap and for good fundamental reasons shrewd investors start to buyinto it, pushing the prices up in an orderly way.
“The price rise is then spotted by the thundering herd who missed out when it was genuinely cheap and so start buying when the market is at a fair value or a little more expensive,” he says. “Finally, people start borrowing money to get in and rampant greed takes over.”
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So what are the signs that should set alarm bells ringing?
Extremes of valuation
Just before the dot-com crash the FTSE 100 was trading on a price/earnings (p/e) ratio of 26 times, compared with a medium-term average of 15 times. At times of irrational exuberance individual stock valuations can become even more absurd. In 1987 the telephone company NTT was listed as the biggest stock on the largest market in the world at the time, the Tokyo Stock Exchange, with a p/e ratio of 250. Two years later it was all over for the Japanese stock market boom as the market crashed.
City experts try to analyse valuations in an objective way by focusing on “fundamental value”. If you establish that the current value being placed on the market is above what it is worth — its fundamental value — that suggests it is in bubble territory. Alec Letchfield, the manager of the HSBC UK Focus Fund, says: “One way to work out fundamental value is to focus on a dividend discount model. This involves projecting forward the future dividends of the markets and discounting them back to their present value.”
The chances of a private investor having the ability to do the calculations are slim. Fortunately, the accountants, PwC, has completed an exercise for the UK stock market based around these principles. It concludes that its UK stock market is still 12 per cent below its fundamental value, so they are far from bubble territory.
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Signs of excess
The problem with focusing only on valuation is that markets can be overpriced for years. PwC’s research suggests that the UK stock market was above its fundamental value throughout the 1990s. Investors, therefore, should look out for other signs of excess, such as easy access to borrowing.
It makes it easier for companies to get credit, boost profits and make the stock market a more alluring place to park cash.
Jeremy Grantham, of GMO, the American-based investment fund, says: “Asset bubbles don’t spring out of the ground randomly. They usually get started based on something real, something new and exciting or impressive, such as unusually strong sales, GDP or profits, which allow the imagination to take flight.
“There is only one other requirement for a bubble to form and that is a generous supply of money. When you have these two factors — a strong, ideally nearly perfect economy and generous money — you are almost certain to have a bubble,” he says.
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Useful indicators
A number of other tools are also available to help private investors to assess sentiment in the market. The VIX index, a benchmark measure of market volatility, tends to drop to a low level during a bubble because the market heads in one direction only — up. You can find details at the website cboe.com.
Analysts also keep an eye on the buying activity of private investors because market peaks are often preceded by a lemming-like rush into shares. In the UK, for example, equity fund sales to retail investors reached a high of £14 billion in 2000 just before investors were plunged into the worst bear market since the Great Depression of the 1930s.
Last year they were £7.5 billion, according to the Investment Management Association.
Can you beat the bubble?
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Spotting a bubble is one thing. Getting out at the right time is another. Despite Mr Greenspan’s claim that bubbles are impossible to spot, he made a famous speech about “irrational exuberance” in December 1996.
Any investor who had pulled out of the market as a result of his warning — stock markets globally fell after the remark — would have missed out on some incredible gains. The FTSE 100 climbed 71 per cent in the following three years before it all went pop as the new millennium dawned.
Mr Griffiths says: “The last stage of a bubble is usually the shortest, but it is often when the most money is made.”
Investors know that prices are crazy, but the “greater fool” theory takes over.
People accept that they are buying high, but think that they can sell at an even higher price to someone more foolish than they are. When the tide turns the falls can be happen at terrifying speed.
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Hard as it is to exit the markets when mania takes over, history shows that the most successful investors are often those who make a decision to quit an asset bubble before it bursts.
They may look on in anguish as the bubble continues to inflate but can feel smug when the house of cards collapses.
Where are today’s bubbles?
Perma-bears such as Albert Edwards, of Société Générale, point out that by focusing on the cyclically adjusted p/e ratio, which compares share prices with average earnings during the past decade, stock markets are overvalued. However, many fund managers disagree. Mr Letchfield says: “There is still value in the stock markets. Compared to other asset classes such as cash and government bonds, equities do not look fully valued. The [regular] p/e ratio for the UK stock market [which focuses on current earnings only] is 11.9 times, which is lower than its medium-term average.”
Mr Griffiths agrees, but says that the seeds of the next equity bubble have been sown by the Federal Reserve’s printing press, which is pumping money into the financial system. He believes that this could also spark a gold bubble, and adds that there could already be a bubble in silver.
Market falls
When a bubble bursts the crash that follows can be devastating.
Here is how much stock markets tumbled during some previous crashes.
Wall Street crash (1929-32)
Dow Jones index down 89 per cent.
Dot-com crash (2000-03)
FTSE 100 down 53 per cent; US Nasdaq index down 78 per cent.
Japan crash (1989-now)
Nikkei 225 down 59 per cent.