Market bubbles everywhere; sorting them out

A failure to identify bubbles has been a recurring weakness of investor psychology. Most are unprepared for the crashes that eventually follow booms. Investors were caught by surprise with technology in 2000 and, more recently, with sub-prime. The risks have usually been missed by most, including regulators.

But now bubbles are being spotted everywhere. Behavioural finance may have encouraged a belated focus on this. Bubble watchers are spoilt for choice, so pervasive is the impact of money printing around the world. Bonds, Asian property and gold are all popular candidates for the bubble of the moment. However, a number of biases still encourage investors to hang on and ride the wave.

Most want to time an exit as precisely as possible, without leaving too much on the table. Collectively, that is never possible. Selling even three months early could miss out on a potential gain of over 30%, as Japan showed this year. With fund managers measured on quarterly performance, and clients very aware of benchmarks, few have the luxury of big long term calls. Timing matters, and that dominates investors’ reasoning.

The asymmetry is also a challenge; markets do not go down in the same manner as they rose. Though shares have risen rapidly this year, it is hard for investors to contemplate an even faster unwinding. The peak of a bubble and its denouement are often compressed into a short period, with little liquidity.

Already, the bond bubble has begun to unwind; whether measured by US 10 year Treasuries or Japanese Government Bonds, selling seems to be underway. The money is steadily moving into equities and property. To date, this is progressing in an orderly fashion, though clearly there is official stabilisation. In Japan, the weakness of bonds will damage the capital ratios of Japanese banks, but they appear convinced that gains on shares will more than compensate. So few seem troubled by the thought that the bond bubble’s best days might be behind it. Investors do not participate in bubbles blindly; a lot of thought goes into them.

Investors tend to blame bubbles on irrational behaviour and crowd mentality, but the factors are typically less obvious. Few are sucked-in unwillingly. There are arguments for why Japan might succeed, or that deposit rates can go below zero, or that Europe might get out of trouble by Eurobonds or unlimited QE. Crowd behaviour offers some clues to where the risks lie, but the challenge is discerning which is the smart money.

The potential for bubbles can be seen in today’s unprecedented intervention. But exactly which is the one that matters most, or when it will be pricked, can be hard to identify. And, the best indicators of bubbles may not be where they are most obvious. The clue to China’s lower growth – with a potential big impact on commodities – might already be indicated by declining imports of key materials from the US and Australia. And, the extraordinary boom in liquidity in China might be best evidenced by Vancouver property prices, luxury good sales in the Middle East or the price of Ming vases in art auctions. Vikram Mansharamani, who wrote Boombustology, makes a strong case for paying attention to Sotheby’s share price, for example. The mosaic can take time to be pieced together, before it reveals a clear picture of unsustainable euphoria.

Asset bubbles have been more frequent in recent years. Markets should spend not more than 5% of the time more than two standard deviations beyond trend. Yet in some stockmarkets and asset classes these extremes of valuation account for more than 10%. As a bubble progresses, investors can become overconfident and trade excessively. In a rising market, sales of stocks from a portfolio will typically be profitable, even if the winners are being sold too soon. This trading activity can be misinterpreted as skill rather than market direction that is delivering profits. Investors can also participate in a bubble through regret aversion. As stocks continue to appreciate, it is easy for investors to believe that they are missing out on profit opportunities.

Bubbles reflect market inefficiency, but that does not mean that behavioural finance can fully explain them. It is more useful for investors to understand the range of behaviours involved, and match them up to what they see happening. Bubble watching has become fashionable, but dealing with them involves thought about investor goals and timescale. Diversification and regular portfolio rebalancing are proven long term ways of controlling bubble risk..

A version of this article appeared in Citywire Wealth Manager in its Behavioural Finance series

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. Data and content provided are for information, education, and non-commercial purposes only. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

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