Investment bubbles
Investment bubbles seem to pop up once or twice a decade and obviously should be avoided. One of the best ways to build a successful long-term investment plan is to simply avoid taking big losses (like when an investment bubble bursts). Two recent investment bubbles that markets have experienced over the past 10 years were the technology stock bubble of 1997-2000 and the housing / real estate bubble of the past 5 years. Both bubbles have created horrible hangovers (and huge losses) for investors who had too much money invested when they burst. It is very difficult (and often takes many years) to compensate for large losses of between 25% and 50%. It’s often tempting to invest in a bubble sector (or stay in a bubble sector) when the market is rising and you hear stories from your peers about how much easy money they are making. Unfortunately, history shows that the risk / reward of doing so is not pleasant.
Common signs of an investment bubble
o Everyone is inside. People who are not normal stock market investors for their investment money. It is very easy to make a quick buck in this bubble sector. You don’t need experience or analysis; just buy what is going up the most. Taxi drivers, school teachers, retirees, and many others who have never invested in stocks are piling up.
o A feeling that you cannot lose. Great long-term secular “history”.
o Dramatic increases in prices / values over 3-5 years.
o The valuation does not matter. Ridiculously expensive appraisal relative to the story. New creative ways to value assets (as using traditional metrics makes them look ridiculous).
o Buy simply because they are rising, not because of any rational analysis. Momentum invest. Buyers are mostly speculators rather than investors.
o Leverage or “creative” financing. Investors in technology stocks that trade daily on margin. Homebuyers using low-interest 40-year adjustable rate loans.
o Artificial reasons that push the market higher.
o Excess liquidity that fuels the increase.
o Big headlines. It’s what people talk about. There are regular stories about the number of billionaires being created daily in the bubble sector.
o Massive and accelerated flows of money from investors in the sector during the last 3 years or more.
The Chinese Stock Market Bubble
The market that currently looks the most like a bubble investing sector as outlined above is the Chinese stock market. Warren Buffet commented on a recent trip to China that he does not find the Chinese stock market attractive after the big surge. Warren has recently been selling off his stake in PetroChina. The Chinese economy is hot right now and growing at around 10% annually. The future of China is a great long-term secular history. The Olympics will be held there in 2008. This is an obvious positive megatrend in today’s world. Bubble markets always have really great stories about why this trend is bigger and better and will last longer than others. The world is different now with respect to the bubble of the moment. You do not understand it? But what do you pay for it?
The Chinese stock market currently exhibits all of the bubble market indicators listed above, as did the older technology housing and stock market bubbles. The Chinese market is now trading at more than 45 times earnings compared to roughly 16 times for the US market. It rose more than 100% in 2006 and has more than doubled again in 2007. The number of new investment accounts in China tripled in 2006. Hair salon workers are talking about which stocks to buy and are “doing their research. “. The Chinese have few other viable investment options now, as fixed income investments underperform inflation. An avalanche of money from around the world has been moving and investing in Chinese stocks. The number of China-focused US mutual funds has expanded dramatically and their inflows have increased enormously. Could the Chinese stock market continue to rally from here (to even more overvalued levels)? Yes, it certainly could. But as a long-term rational investor, in my opinion, the risk / reward is not favorable at the moment.
What usually causes the end of a market bubble?
o Excess supply / reduced demand. High prices attract more capital, drastically producing more supply from the bubble asset (more technology IPOs / equity issuance, more housing construction, more IPOs / equity issuance in China). The housing bubble caused home prices to skyrocket so that the average home buyer could no longer afford (without creative financing) to buy an average home. This reduces demand.
o An economic shock or an external shock such as a recession, a terrorist attack, etc.
o Simply market fatigue as excess optimism wears off. Once stock prices start to fall, there is a stampede to the exits that is just as dramatic as the rise. At that point, people start selling just because the price is going down, just like they bought simply because the price was going up.
o The Chinese stock market could be in trouble for a number of reasons, such as rising inflation in China (food, energy), a stronger currency that together with inflation erodes part of its competitive advantage, economic growth that is slows from the current very strong (10%), government actions to slow the economy / stock market / inflation, dramatic increases in the number of shares being issued there, and changes in the rules of the stock market that allow Chinese investors invest some of your money outside of China (and in other markets like Hong Kong). Chinese stocks have moved somewhat in recent months. I’m still bullish on China, but not bullish on Chinese stocks at the moment.