5 (near) sure signs that market is in bubble territory
Most people think it is really difficult to spot a bubble before it bursts. That’s probably true nevertheless there are definite indicators we can look to and sometimes they are very very apparent.
Here are the five signs which would make me stop cold in my investment tracks.
1. A significant disconnect between investment returns and valuation as compared to historical norm
First we must ask what is an investment?
For me an investment is a resource of some sort that has an inherent return of some sort.
Note that this would exclude things like precious metals(gold, platinum etc.) and foreign currency holdings. No doubt these assets could deliver great return, but there is no way for an investor to predict which way they would move in future(beyond perhaps appreciating in line with inflation in long term).
The most common investments thus are property, fixed return bonds and shares. All of these earn a return of some sort in return for risk you take.
To illustrate say I buy a house today for £100,000. In order to work out the expected return I would need to know the current market annual rental. Further I would need to know the costs involved in maintaining and renting out the house including the expected void periods. I would than divided this by purchase price plus the purchase cost to work out the investment return.
If the expected yield is way out of last 20 year’s average than this is a very powerful indicator that assets have gotten too pricey.
As an example at the peak of the U.S. market in 2006, the rental yield had fallen to 5.42%. The long-term average (from 1989 to 2003) was 10.45%.
Caveat: One must consider structural changes in the market which could indicate that lower returns are a new norm. This for example would apply if you look at return expectation from property in Sri Lanka before and after the war. As war ended the market moved from high risk to medium risk thus moving the rental returns to more global average. In this case one could conclude that disconnect is only appropriate and not a sign of property market bubble.
On the other hand I don’t think the current low interest rate environment represents a significant structural change in economy. The market is awash with liquidity created by central banks but the interest rates would revert to the mean sooner or later. And when they do one asset class they are bound to destroy is the fixed interest rates bonds of any sort.
2. Prices are rising too fast net of inflation
There can be many reasons for a real increase in price of an asset. In some cases the market or economy structure is changing for good. If there is a large increase in population or if a country opens its doors to outside World as for example has recently happened with Burma than a large increase in asset prices can be expected.
Beyond that a too rapid rise in prices indicate bubbles. Note this is in a way a sub-set of the indicator above. As the increase in prices would result in disconnect in returns and valuations unless the profits/rent is also increasing by the same factor. This rarely happens.
3. Assets are being bought with debt finance beyond what is usual in the market
High leverage ratio is one of the clearest indicator of a bubble market. Each asset class has a different normal leverage ratio. So for example 100% mortgages are common in developed countries. In 2007 it was common to find even 125% mortgages in US market.
For stocks most people invest with their own money and you would only expect sophisticated investors to deal in buying on margins.
Looking at 2007 again as an example we can see that by 2007 U.S. households had become increasingly indebted, with the ratio of debt to disposable personal income rising from 77% in 1990 to 127% at the end of 2007, much of this increase mortgage-related
4. When people who have no business being in a business are seen advocating the business it is time to bail out of the business!
This one is not scientific but sadly represents the inherent herd like mentality of human race.
When your taxi driver starts chatting about his stock selection and your GP about his Spanish time-share property investment it is most likely time to move on. That is a sure sign that prices are driven by hype and buzz rather than fundamentals.
5. %age of activity contributed by a service dealing with an asset class is way too high.
When gold prices were touching 1,800 USD per ounce you could see shops opening in mall offering to value and pay for your gold there and then. A few companies were offering to do the same for your old gold jewelry via post!
In 2007 it felt like every second person was either estate agent or thinking of becoming one.
In last stages of a bubble amateurs rule as they haven’t been burned before and don’t have much perspective. They are the ones hyping up the market and buying into it at the same time.
The above are only indicators however if all five were present in a market than I would not touch it with a pool.