July 25, 2014 9:17 am
Market mania: a ‘how-to’ guide to hot assets
From spotting the signs to timing your exit, profiting is tricky
Meanwhile, biotech stocks have gone ballistic; they rose 15 per cent a year from the 2002 low to the 2008 peak, 25 per cent a year from the 2009 low to the start of last year, and at an annualised rate of 50 per cent since then.
Bubbles compared
The housing bubble has been the talk of every London dinner party for a couple of years. But during the past year it has become hard to have a discussion about the valuation of equities, junk bonds, art or emerging market debt without questions being asked about whether prices are overinflated.
In the US and UK financial press there have been with more mentions of market bubbles in the past 18 months than any time before.
During the 17th and 18th centuries, “bubble” was used to describe fraud or deception, as the South Sea Company turned out to be. Speculative manias often involve lots of fraud – as post-boom bank fines are still demonstrating – but economists these days tend to focus on the speculation, not the deception.
One widely used definition is that prices are well above what could be justified by any reasonable expectation of future profits. Unfortunately, no one agrees on what counts as reasonable. Social media or biotechnology shares demonstrate that one investor’s rational expectation is another’s bubble.
Jeremy Grantham, chief investment strategist of fund manager GMO, takes a more mathematical view. He defines a bubble as when prices rise two standard deviations above their norm – something that would occur once every 44 years if markets behaved as statisticians would like.
Markets, of course, are not so neat, and Mr Grantham has found sizeable bubbles forming about every 31 years, although with many more minor bubbles. Of the 330 he has identified, only 30 did not burst, at least so far, and all were in obscure assets.
Other definitions are more restrictive, requiring obvious speculative excess or the danger of significant damage to the economy. Plenty of small “bubbles” would not qualify, because they hurt only a handful of investors when they popped, including recent booms and busts in 3D-printing stocks or rare earths miners.
Cliff Asness, founder of hedge fund AQR, tries to limit talk of bubbles to extreme valuations, as in the dotcom bubble, and not including cases where stocks are merely expensive (as now).
Bubbles tend to inflate in two types of asset: those that are hard to short, or bet against, and those with little in the way of profit or dividends to provide a basis for valuation. Housing fits both, with the additional advantage of being easy to gear up.
Dotcoms in 1999, railway stocks in the 1840s, and the various canal manias of the 1790s onwards added in the excitement of a new technology with the promise of upending traditional valuation metrics.
Having decided what a bubble is, investors face two questions: can they spot one and, if so, how can they make money from it?
Mr Chancellor has four rules of thumb for spotting a bubble. Price, obviously, must be well out of line with norms. Expectations must look obviously unrealistic. There should be widespread evidence of fraud. Finally, money should be easy, thanks to either central banks or financial innovations.
Having spotted one, how can one make money? Jim Chanos, founder of New York hedge fund Kynikos, says the trick is to focus on “booms which go bust” in order to have a sense of when the bubble will burst. That means looking for booms backed by debt used to finance assets that do not produce enough cash to service the loans.
“The fuse tends to be much shorter on these kinds of situations,” he says. “In equity valuation bubbles the valuation can keep going up indefinitely.”
During the dotcom boom that meant short selling the highly geared equipment and internet cabling companies, not the dotcoms themselves. Today, it means betting against China.
Kyle Bass, founder of Hayman Capital Management, a Dallas hedge fund, has a similar view. “The hard part is not identifying the bubble; the hard part is identifying the timing,” he says.
Dotcom unbelievers changed their tune, lost their jobs or saw their clients pull out. Those early to spot the subprime bubble had a tough time keeping customers on side, too. Mr Bass timed subprime well and followed up by betting against Greece.
Now he is short Japan, via the options market. He has been less lucky here, having held the position for four years. But he says the “epic” mispricing means it is so cheap to bet against Japanese bonds that he could lose money for eight years and still do well overall if he is right.
The debate is still on about equities. Mr Grantham says the S&P 500 needs to hit 2,250 (from 1,988 as of Thursday’s close) to qualify as a bubble, but he expects it to get there.
The prudent investor faces a dilemma. Bubbles are best avoided, given the difficulty of getting the exit timing right. But when the Fed is pumping in air, where else can they put their money?
This article is the first in a series
Copyright The Financial Times Limited 2014.
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