Five criteria to identify asset bubbles10 October, 2010, 22:44. Posted by Zarathustra
Asset bubbles are not easy to determine if not with the benefit of hindsight, especially when the bubble was still in the early stage of making, it might be hard to distinguish between a bubble or a boom with good fundamentals. Investors might not want to be cautious with early-stage bubble as it might be the best for them to join the party, but it would be very useful for investors to have some idea on how a late-stage bubble would look like so that they can get out of the market on time. As we are now in a very chaotic situation, I thought it might come in handy if there are some guidelines to help readers and myself to identify asset bubbles.
Photo by Cristian Bortes, Creative Commons
1. Asset Prices increase like a rocket
This sounds like a no-brainer, but for sure this is the prerequisite. The fact is even in prosperous time, stock prices rarely go in one direction for months, and there are always ups and downs in the market even in the fastest growing economy. If asset prices are going up for long time, it should be time to be cautious.
2. Even the general public talks about investing
Investing would not normally be a hot topic on dining table or some drink receptions. But in a time of bubble-blowing, everyone is interested in investing, from bankers to salesman, from professionals to students, everyone is talking about investing. When you see huge queue outside a bank or brokerage house for an IPO, for example, that is a sign of bubble-blowing.
3. Every investor seems to be winner
Because the market is doing very well, most people in the market seem to be winners. Newspapers will tell a lot of stories on how a housewife become a millionaire, or how a college student gain HK$10m in a simulated stock trading competition. Of course, when the market is only going up, as long as you are not shorting, you are a winner.
4. Even people who did not invest before invest now
If you try to figure out which period of time are there the highest number of first-time investors entering the market, it must be in the time of bubble-blowing. Because the market is doing well, and every investor seems to do well with many great stories of how someone become a millionaire in months, this attracts many novices who wish to make some quick profit from speculating.
5. “This time is different” syndrome
Yale economist Irving Fisher was a bright economist who devised the Fisher hypothesis on interest rate. However, he famously claimed that “Stock prices have reached what looks like a permanently high plateau.” He lost almost his entire wealth in stock market. Although there are some people have tried to justify his claim, as far as bubble is concerned, this is irrelevant (In fact, if you use the dividend-discount model to calculate the theoretical share price at 1929 by using dividends paid from 1929 to present, I would not be surprised if that the share price in 1929 before was at least correctly valued or cheap. However the market is not rational, and no people can really predict dividend payments to eternity).
The key point is people, amateur and professional analysts alike, would try to come up with reasons that the current rise in asset price is not a bubble, rather it is supported by strong fundamentals. You do not need to look elsewhere but to read the book “This Time is Different” by Carmen Reinhart and Kenneth Rogoff