With all the recent talk about new bubbles forming, I thought it timely to review what a bubble looks like.
How do you identify a bubble? Here are a few things to look for:
1. Experienced, older investors stay away while novices invest in droves.
Older investors tend to have learned from prior bubbles and busts, while less experienced investors feel and act as if they were invincible.
2. The justification for continued asset appreciation has little to do with profits.
A ‘new paradigm’, unique measures of success or the promise of huge profits years into the future are usually signs that fundamentals are not sound.
3. Insiders (e.g. company executives, company treasury) selling stock.
Insiders tend to have the best knowledge on their company and industry prospects. If insiders don’t believe the hype, should anyone else?
4. Mainstream media is all over the asset class/sector.
Remember all the reality TV shows about people buying, renovating and flipping houses? By the time an asset or investment becomes so popular that average people want to spend their free time dreaming about the money to be made, the party is usually over.
5. The lifestyle of the average citizen becomes extravagant.
When people with average incomes start to live above-average lifestyles (frequent vacations, expensive cars, etc), it is usually a sign that people are living beyond their means by using easily accessible credit. When credit is easily accessible a portion of the abundant credit moves into the hands of speculators creating asset market bubbles. On the flip-side, asset bubbles may have funded the extravagance. Regardless, when wealth creation isn’t real it usually ends up vanishing.
6. People make more money investing than working. Speculation becomes a career for many.
Investments should be based on the value creating capabilities of companies, which are grounded by returns on land, labor and capital. If average people make more money owning shares of companies compared to building companies, it is a sign that the corporate value creation capabilities are weak relative to asset returns. [It is also a sign that assets are over-levered, as that is the easiest way to squeeze higher returns out of marginally profitable companies. But asset prices can only go so far before fundamentals pull them back down to earth and borrowers are wiped out.]
7. Asset prices fueled by credit–>Credit expansion justified by rising asset prices.
This is a feedback loop where higher asset prices support greater credit extension, which leads to even higher asset prices. The opposite becomes true once the feedback loop reverses.