How to recognise and benefit from a financial bubble

By Larissa Fernand |  29-01-19 | 
 
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About the Author
Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

When former Federal Reserve Chairman Alan Greenspan characterized the financial crisis of 2008 as a “once-in-a-century credit tsunami” Paul Kaplan, then Morningstar’s vice president of quantitative research, recollected being stunned.

He believed that a more apropos statement was the one made by Leslie Rahl (founder of Capital Market Risk Advisors): “We seem to have a once-in-a-lifetime crisis every three or four years..”

The contrast in perspectives led him to pen down a post Déjà Vu All Over Again on the history of meltdowns.

This came to mind as I read an engaging post titled Why financial bubbles burst, by Ruth Saldanha, Morningstar’s senior editor based in Canada. The article could not have come at a more appropriate time.

In the U.S., the debate rages as to whether marijuana stocks have crossed the threshold from boom territory to bubble mania. Last year, Constellation Brands (maker of Corona beer) invested $4 billion into Canopy Growth, making the debate all the more heated. Then there was the Bitcoin bubble. And, of course, all through 2017 and for the better part of 2018, we were told to be wary of the Indian stock market bubble.

Bubbles are real.

It could be an asset bubble, or a bubble in a specific sector.

Bubbles will always exist. Right from Tulipmania in 17th-century Holland to the GFC in the 21st century.

Neither are they difficult to spot; starkly rising asset prices and “hype” are usually a good starting point. While they are not difficult to spot, it’s correctly calling the time of the bubble popping that is the problem. It could go on for weeks, months or, maybe, years. Take the March 2000 bursting of the Internet bubble; a number of years prior, the market for Internet stocks exhibited signs of speculative excess. Many ignored the irrational increase in prices. In 2007, almost all Telecom, Power and Capital Goods were the rage. If you kid yourself into believing it is a healthy bull run and throw caution to the wind, you could jeopardize your life’s savings.

In Understanding and Mitigating Bubbles, Rodney Sullivan writes that although each bubble environment has its own distinguishing characteristics, certain common elements persist as key ingredients in bubbles over time: Innovation or the perception of it, speculative leverage, and the emotion and psychology of investors – collective delusion. Everyone gets excited and engaged and does not believe it will ever end. The question of downside ceases to exist.

It's a confluence of these three factors at play. None are independent, they are all intertwined in a way that leads to bubbles.

Sankaran Naren, executive director and chief investment officer at ICICI Prudential Mutual Fund, divides the market into four cycles:

  • Bust (2002, 2008, 2013)
  • Best (2003 to 2005 and 2014 to 2016)
  • Boom (was how he described 2017 where money was flowing into equity mutual funds)
  • Bubble (1999, 2007)

“Boom is the period where money can be collected in a big way, post which the Bubble phase comes in. It is crucial in this phase one cuts risk in their portfolio and pays respect to asset allocation. On paper it looks extremely easy, because what you're doing is booking profit. But in practice, looking at 1992, 1994, 1999 and 2007, it's very difficult,” he says. (Using the above classification, where are we now?)

Naren is extremely influenced by the writings of Howard Marks, who brilliantly explains the concept here.

Marks believes that the presence of “bubble-thinking,” is where investors take a grain of truth and run away with the concept. In the late 1990s the grain of truth was that the internet would change the world. People took that to mean that if you invested in an internet or e-commerce company, you’ll probably make a fortune and it didn’t matter what price you paid.When you reach the point where people have separated value and price considerations from platitudes.. and you hear people say price doesn’t matter, then you’re in bubble land.

In Why financial bubbles burst, Morningstar’s senior investment analyst Shehryar Khan shared insights that can serve as a guideline for investors.

  • Investors can benefit from bubbles by being contrarian.

A bubble will typically result in great scrutiny being placed on one or two areas of the market, leaving others ripe for the picking. Despite the broad brush that companies that operate in the sector get painted with, there are some good companies that long-term investors can target.

The two biggest traits to succeed in investing are having the mindset that allows an investor to be comfortable going against the tide, and the patience to wait for their thesis to play out.

  • The best way for investors to differentiate between a new business and a trend is to do their homework.

They should consider whether the business they are analyzing has earnings. A company may not necessarily be profitable if it is reinvesting heavily into their operations to grow their business, but the company needs to demonstrate an ability to generate profits at some point in the future.

  • Investors need to evaluate how much they are paying for a business.

Paying 30, 40, or 50-times earnings is generally not a recipe for success, as a great company can be a bad investment if bought at too high a price. Sometimes, finding a great business means having to wait a number of years before the market offers up the opportunity to buy it at an attractive price, but that is part and parcel of being a disciplined investor.

  • Investors need to monitor their investments.

This is to ensure that the reason they bought a company in the first place is progressing as expected. Companies can fail to execute on their strategies for a whole host of reasons, poor management, changing industry dynamics or sheer bad luck.

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