Investment bubbles happen once or twice a decade it seems, and of course they should be avoided. One of the best ways to build a successful long-term investment plan is to simply avoid big losses (like when an investment bubble bursts). Two recent investment bubbles that markets experienced over the past 10 years were the tech stock bubble of 1997-2000 and the real estate/housing bubble of the past 5 years. Both of these bubbles created horrible hangovers (and big losses) for investors who had invested too much money when they burst. It is very difficult (and often takes many years) to compensate for large losses of 25% to 50%. It’s often tempting to invest in a bubble sector (or stay invested in a bubble sector) when the market is booming and you’re hearing stories from your peers about how much money they’re making easily. Unfortunately, history shows that the risk/reward ratio of doing so is not pretty.
Common signs of an investment bubble
o Everyone is in it. People who are not normal stock investors pour their money into investing. It’s so easy to make a quick buck in this bubble industry. You don’t need any expertise or analysis; just buy what goes up the most. Taxi drivers, teachers, retirees and many others who have never invested in stocks are piling in.
o A feeling that you can’t lose. Great long term secular “story”.
o Dramatic price/value increases over 3-5 years.
o Evaluation does not matter. Ridiculously expensive valuation compared to history. Creative new ways to value assets (since using traditional metrics makes them ridiculous).
o Buy simply because they are going up, not because of rational analysis. Dynamic investment. Buyers are mostly speculators rather than investors.
o Leveraged or “creative” financing. Tech stock investors trade on margin. Homebuyers using 40-year variable interest rate loans with low incentives.
o Artificial reasons pushing the market up.
o Excess liquidity fueling the upside.
o Headlines. That’s all people talk about. There are regular stories about the number of billionaires created daily in the bubble sector.
o Massive and accelerated investor inflows into the sector over the past 3 years.
The Chinese stock market bubble
The market that currently most closely resembles a bubble investment sector as described above is the Chinese stock market. Warren Buffet said on a recent trip to China that he did not find the Chinese stock market attractive after the sharp rise. Warren recently sold his stake in PetroChina. China’s economy is booming right now, growing at around 10% a year. China’s future is a big long-term secular story. The Olympic Games will be held there in 2008. This is a positive mega-trend evident in today’s world. Bubble markets always have great stories about why this trend is bigger and better and will last longer than others. The world is different now compared to the current bubble. You do not understand ? But what are you paying for it?
The Chinese stock market is currently exhibiting all of the bubble market indicators listed above, much like past bubbles in technology stocks and the property market. The Chinese market is now trading at around 45+ times earnings, compared to around 16 times for the US market. It grew by more than 100% in 2006 and more than doubled in 2007. The number of new investment accounts in China tripled in 2006. Employees of beauty salons discuss stocks to buy and “do their research” . The Chinese now have few other viable investment options, as fixed income investments pay less than inflation. An avalanche of money from around the world moved in and invested in Chinese stocks. The number of China-focused U.S. mutual funds has increased dramatically, and their inflows are up massively. Could the Chinese stock market continue to climb dramatically from here (to even more overvalued levels)? Yes, it is certainly possible. But as a rational long-term investor, the risk/reward ratio is not favorable right now in my opinion.
What usually causes the end of a stock market bubble?
o Excess supply/reduced demand. High prices attract more capital, which produces significantly more supply of the bubble asset (more IPOs/tech stock issuances, more home building, more IPOs in Chinese stock market/equity issues). The housing bubble caused house prices to rise too high, so that the average buyer could no longer afford (without creative financing) to buy the average home. This reduces demand.
o An economic shock or an external shock such as a recession, a terrorist attack, etc.
o Simply market fatigue as excessive optimism wanes. Once stock prices start falling, there is a rush to exit that is just as dramatic as the surge. At that point, people start selling just because the price goes down, just like they buy just because the price goes up.
o The Chinese stock market could struggle for a number of reasons such as rising inflation in China (food, energy), a stronger currency which along with inflation is eroding some of their competitive advantage, economic growth slowing from the current very high (10%), government actions aimed at slowing the economy/stock market/inflation, dramatic increases in the number of shares issued there and changes stock market rules that allow Chinese investors to invest some of their money outside of China (and in other markets like Hong Kong). Chinese stocks have rebounded somewhat in recent months. I’m still bullish on China, but not on Chinese stocks right now.