Bubble alert: a 'how-to' guide to hot markets

A 9 foot by 18 foot London garage is for sale for £500,000. An anonymous buyer just paid £2.5m for a bed because artist Tracey Emin arranged vodka bottles and condoms next to it.

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.

"Everyone's on bubble watch," says financial historian Russell Napier. "We all have to be on bubble watch because the central banks are on bubble watch."

The housing bubble has been the talk of every London dinner party for a couple of years. But over 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.

This is reflected in the US and UK financial press, with more mentions of market bubbles over the past 18 months than any time before (see chart).

But what actually is a bubble? Economists disagree, to the extent that some - led by Eugene Fama, father of the efficient markets hypothesis - deny there is such a thing. The only point the rest agree on is that a bubble has to end with prices coming down, at least after adjusting for inflation.

During the 17th and 18th century "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 tend today 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 ever agrees on what counts as reasonable. Social media or biotechnology shares are once again demonstrating 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 which 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 major 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.

Others are more restrictive, requiring obvious speculative excess or the danger of major damage to the economy. Plenty of small "bubbles" would not qualify, after hurting 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 really extreme valuations, as in the dotcom bubble, rather than when stocks are merely expensive (as now).

Yet, bubble-spotting is all the rage. Edward Chancellor, a former fund manager and author of a history of speculation, says central bank easy-money policies means "we have the financial conditions for a bubble".

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, all 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 it, 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, either thanks to 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 Dallas hedge fund Hayman Capital Management, 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, followed up by betting against Greece and is now 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 expects it to get there.

"We're in the hands of the Fed, and as long as the Fed means to keep this game going - as it clearly does - the chances are that the market goes from overpriced to even more overpriced," he says.

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?

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Twitter: @jmackin2

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