How to Identify a Bubble

How to identify a bubble?

What is a bubble? Investopedia defines it as “a rapid escalation of asset prices followed by a contraction, often created by a surge in asset prices that is fundamentally unwarranted.” In layman’s terms, this is when prices of assets like stock, real estate etc. rise way beyond what seems to be justified. Of course, this is highly subjective. It is difficult to get any kind of consensus on what the price of an asset should be. Bubbles can arise in any type of market. It can occur in commodities, even fine art, and most famously the tulip bubble in Holland from 1634 to 1637. The bottom line is that a bubble can be created using anything at all. However, most investors are focused on financial bubbles.

Difficulty in spotting and timing it

Most texts suggest that bubbles are much easier to spot after the fact. This is not what investors what to hear. Most people would prefer a 1-2-3 guide for spotting them and would love a six-month window of escape. In the aftermath of some of the bubbles, some people have specialized in trying to predict the next bubble. This, however, is rife with difficulties. One such is that there are some people who predict bubbles in the U.S. stock market every single year. This is especially pointed since the U.S. stock market has been in a bull run since 2009. Following the announcement that the U.S. and China reached a phase one trade agreement in December, all the major U.S. indices have been achieving records. So, what’s the danger here? People who call down “doom and gloom” all the time, must be right at some point, right? That is inevitable. But listening to them can cost you a lot of money in terms of missed opportunities.

Signs

There are a few signs that you can look out for, and I will just list them. They include a rapid deterioration in market liquidity, a large disconnect between prices and value, claims of easy wealth (i.e. getting rich off trading assets with no expertise needed), a rapid exit of smart money (this includes the connected, rich people, institutions), and of course the rapid entry of retail investors (small people).

How to protect yourself

Avoid entering a market when you hear key words like prices are at “record highs”. Follow your gut- just because everyone is doing something doesn’t mean you have to join in. Don’t put all your funds in one asset class. Don’t be emotional-check carefully the track record of the person giving advice. Do they always think the worst is going to happen, no matter what the facts are? Check the overall market conditions. Are things looking good? Are there advancements being made? What is business confidence looking like? There is no foolproof method for avoiding a bubble, but common-sense investing can go a long way! Happy New Year!!!

Yanique Leiba-Ebanks, CFA, FRM, B.S.B.A.

Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: if you wish to have Sterling address your investment questions in upcoming articles, e-mail us at info@sterlingasset.net.jm.