Did your Uber driver just give you a stock tip? We're in a Bubble...

 

Market bubbles are expanding and potentially bursting all over the world. The recent Brexit decision will undoubtedly pop--and maybe even expand--many of them.

Now is an especially important time to understand the stages of bubbles. History shows us that the first documented bubble, Tulip Mania, four centuries ago, had a pattern that’s been repeated throughout financial market history. This pattern is playing out now in markets around the world.

To recap, the basic stages of a market bubble as presented by Jean-Paul Rodrigue, a Canadian transportation scholar, are:

1.     Stealth phase: A new market premise or investment story is recognized by a small number of early adopter, “smart money” investors.

2.     Awareness phase: The market is trending higher, the media has picked-up the story and an increasing number of investors are joining in.

3.     Mania: Continually higher prices and media stories that seem to justify the price gains, form a feedback loop driving ever increasing price momentum.  “Easy” profits have intoxicated investors who project recent experience irrationally into the future.  

4.     Blow-off. Price gains stall. Pessimistic stories gain traction, causing more selling, amplifying the bearish story. The bubble pops--buyers disappear, and a negative feedback loop develops as falling prices cause more selling. Prices crash, typically falling 50%, but sometimes falling below pre-bubble levels.  

So how does an investor make money on market bubbles, or at least keep from getting hurt when they burst?

·       Get in early during the stealth phase, before it’s a bubble. George Soros, one of the greatest traders in history, said in 2009: “When I see a bubble forming, I rush in to buy, adding fuel to the fire.”  Discovering an investment story and sensing it’s bubble potential, before it’s headline news, is key.

Example 1: In August of 2014 the Chinese government, faced with a slowing economy, lowered margin account rates. The Chinese state-controlled media ran multiple stories promoting the benefits of stock market investing.

What the “Smart money” saw: The Chinese government was embarking on a mission to drive share prices higher. What happened? The Shanghai Composite Index was at 2338 on August 29, 2014 and topped at 5166 on June 12 2015, a gain of 120%.

Example 2: In March of 2009, the U.S. Fed, concerned with a slow post-recession economic rebound, initiated quantitative easing (QE1), announcing the FED would buy US$1 trillion of Treasury Bonds, by “printing” money that did not exist before hoping to stoke the economy.

The “Smart money” opportunity: The U.S. Fed was prepared to flood the U.S. economy with money. It was “risk on” in a big way.  QE1 ran from March of 2009 until April of 2010 and coincided with a nearly 70% rise in the S&P 500.

·       Catch the trend in the Awareness Phase, if you missed being early, you might get another opportunity, before irrational exuberance takes over.

            Example: In September of 2011, the U.S. Fed announced “QE2”. While QE1 caused a big rise in stock prices, the US. Economy was still sluggish in the fall of 2011, and U.S. stocks were languishing--investors were getting bearish.  An additional round of massive easing was announced.

            The Smart Money opportunity: Studying the only precedent for Quantitative Easing-- Japan in the 2000s--astute investors saw that Japan’s QE1 caused the Nikkei to rise 50%. QE2 drove Japanese stocks up 80%. If the U.S. Fed was starting its version of QE2, odds favored a second leg up of the bull market. The S&P 500 rallied nearly 20% over the next six months.

·       Wait patiently for an “inverse bubble.” Just as irrational exuberance can carry a market much higher than underlying economic realities justify, so can investors oversell markets in bouts of irrational pessimism. The investment public has a short memory, but the terrible market plunges of 2008 and 2009 were not that long ago. The recent Brexit sell-off might jostle the memories of anyone lulled to sleep by ever rising asset prices. As global markets get jittery, make a list of the best companies, or markets you’d like to own. Determine price levels that would make these investments bargains, and if panic drives shares to your level. Buy, buy, buy.

·       Avoid markets and securities in the Mania Phase. It’s not easy to leave a great party, but the best investors are contrarians. If everybody loves the market, stay on the sidelines.

Example:  When the Shanghai Composite broke above 4000 on April 10 of 2015, up about 80% in eight months, investors--mostly unsophisticated retail traders-- were pouring money into the market. Brokers were opening four million new trading accounts a week to meet demand. Margin lending had increased to a record, 250% greater than six month earlier.

Yet, the People’s Daily, the mouthpiece of the Communist Party, declared that the bull market was "just beginning." Stock-mania had overtaken the Chinese stock market.

On June 8 of 2015, the Shanghai Composite closed at 5353, up about 130% in ten months.

Mainland speculators had borrowed $348 billion to bet on further gains. Despit the huge gains in less than a year, the Chinese were the world’s most optimistic investors, according to a Legg Mason  and Citibank survey. About 60% of them planned to increase their equities over the next year.

The economy meanwhile, was mired in its weakest expansion since 1990. Price-to-earnings ratios had climbed to the highest level in five years.  At the Shenzhen exchange, famous for its many tech firms, half of stocks with analyst estimates have a forward PE above 50, In the past year, almost half of all shares in Shenzhen have doubled in price or better.

The head of a financial research firm in Hong Kong was quoted as saying, “We have a wonderful bubble on our hands. Of course, there’s short-term money to be made. But I fear it will not end well.” Turns out he was correct on two of those three statements.

Price-to-earnings ratios had climbed to the highest level in five years.  At the Shenzhen exchange, half of stocks with analyst estimates had a forward PE above 50. In the past year, almost half of all shares in Shenzhen had doubled in price or better.

When your friends and neighbors are day trading or flipping houses, gloating over their profits, when your barista is speculating on condos, or your Uber driver is giving you stock tips, it’s probably a bubble. Look out below.

 

Mark Gaffney