Financial Bubble about to burst?

16038322_ed04_625x1000"Double, double toil and trouble. Fire burn and cauldron bubble."

Shortly after the three witches cast their spell, Macbeth enters to enquire about his future and the three witches tell Macbeth about a number of things he should be concerned about. If Macbeth was an investor in today’s markets I wonder if he would have been warned about another kind of bubble (not involving the eye of a newt and the toe of a frog) – namely a financial bubble.

In financial speak, the term “bubble” refers to a condition in which asset prices appear to be inconsistent with underlying fundamentals. Distinguishing between the real value of an asset and its market value is not an exact science and as such many financial bubbles are viewed in retrospect. Bubbles in nature are simple, perfect and beautiful. Investment bubbles can seem the same way at the beginning – perfect and so beautifully simple. You put money in and it grows, what could be easier or more rewarding than that? Nature’s bubbles are incredibly delicate though and are all destined to eventually pop, gone forever. Economic bubbles are the same, but it takes a while for people to see how fragile they are, often not before it is too late.

One of the earliest, perhaps first, bubbles happened during the mid-seventeenth century in the Netherlands. Referred to as “Tulip Mania”, from 1634-1637, tulips became a fad among the rich of Holland, and prices began to mount. Soon even ordinary bulbs were selling for extraordinary prices, and the prices of rare bulbs were astronomical. A single Viceroy Tulip bulb would sell for a value roughly equivalent to $1,250 in current terms, while a rarer Semper Augustus bulb could easily go for twice that. At the height of the mania, in what seemed a complete loss of sanity, the bulbs were deemed too valuable to risk planting by their (formerly) wealthy purchasers, and it became popular to display the plain ungrown bulbs. In at least one instance the plan for safety backfired when a visiting sailor mistook a tulip bulb for an onion, and proceeded to eat it for breakfast.

The height of the bubble was reached in the winter of 1636/37. Tulip traders were making (and losing) fortunes regularly. A good trader could earn up to approximately $61,710 in current terms. With profits like those to be had, nothing local governments could do stopped the frenzy of trading. Then one day in Haarlem a buyer failed to show up and pay for his bulb purchase. The ensuing panic spread across Holland, and within days tulip bulbs were worth only a hundredth of their former prices. The tulip bubble had burst.

Gouda_Tulip_BulbsLooking back through time it is easy to laugh at the foolish Dutch, paying such prices for simple tulip bulbs, but an economic bubble was nothing new even then. We are still doing the same sorts of things today. Human beings have always been prone to want things that are difficult to get, especially if everyone else seems to be doing it. Nutty behavior becomes commonplace when enough people are following along. It is 0nly afterwards that we stand back and shake our heads and wonder what came over us.

But, are there any ways to foresee a bubble coming? Is it really possible to spot a bubble on the horizon? Yes, there were those few that spotted the housing bubble of 2007/08 (well done Mr. Paulson). There were also those few that spotted the tech bubble of 2000. Did they get lucky when timing the prediction or do us investment managers have the ability to spot economic bubbles forming?

If they can be spotted, what were the warning signs? There has to be a warning since a bubble doesn’t happen overnight, right?

RealCap is of the view that there are at least 4 warning signs that signal the existence of a potential financial bubble in financial markets today:

  1. Rapid rise in prices of assets

    • In March of 2014, the S&P 500 Index was up 173% from the March 2009 bottom, making the current rally the second best performing bull market over a five-year time period since World War II. Another example is when the NASDAQ rose 110% in the 12 months before the dot-com bubble crested on March 10, 2000.
    • SP500
  2. Prices vary significantly with an asset’s underlying value

    • With stocks, one popular way to measure value is to divide the market price by its 10-year average earnings after adjusting for inflation. Using this method, Robert Shiller, a Yale economist and Nobel Prize winner, tracks data using his Shiller P/E method. According to the Shiller P/E the median ratio of stocks since the late 1800’s is 16, while during the dot-com bubble, it surpassed 44. Currently, the Shiller P/E ratio of the S&P 500 is approximately 25.
  3. New and exciting technology or innovations are serving as explanations for rising prices

    • This is what happened when the dot-com bubble burst. As the bubble formed, individual investors poured money into the asset class. This has also happened in our historical past with innovation that caused disruptive change, such as American colonization or the invention of the railroad.
  4. Mergers and Acquisitions are fetching historical premiums

    • United States mergers and acquisitions have not been this successful since 2006 with historic deals taking place. An example of the sort of acquisition described here is the recent Facebook acquisition of WhatsApp for $19 billion.

Even with the above warning signs prevalent in today’s markets, it is very difficult to accurately predict the future of a market which is irrational at the best of times. As such, while it is conceivable to tell when a bubble is forming, when it is going to pop is impossible to discern. When all is said and done, the winner in the ongoing debate regarding whether global financial markets are currently in a bubble about to burst will be Captain Hindsight.

Our view is definitely one of caution. Perhaps now is the time to decrease market exposure and take some time off to smell (not buy!) the flowers?