Asset bubbles: Looking out for the red flags

Asset bubbles are not a new phenomenon in the financial markets though they have become more popular in the last two decades due to the significant market crashes of 2000 (Dot-com crash) and 2007 (Sub-prime mortgage induced crash). The first asset bubbles in the history of financial markets date as far back as the 17th century with the “Tipper and See-Saw Time” and “Tulip Mania” bubbles in 1621 and 1637 respectively.

According to the Federal Reserve Board of San Francisco, an asset (price) bubble describes a situation in which an asset price has risen above the level justified by economic fundamentals, as measured by the discounted stream of expected future cash flows that will accrue to the owner of the asset. This results in over-inflated asset prices fuelled by excess and persistent demand for assets as investment vehicles.

Unfortunately, bubbles do not last forever, and are typically followed by busts, more commonly described as market crashes. Indeed, the bubble bust cycle makes for two possible outcomes – an exponential growth in wealth of investors, or a devastating erosion of capital leaving investors frustrated. It is therefore important for investors to be able to identify the warning signs of asset bubbles in order to avoid being caught on the wrong side of the tide. This is even more important for investors who do not have an overly strong appetite for risk.

Consequently, we highlight below, some of the most evident signs of asset (price) bubbles.

Excessive valuations

This is probably the clearest sign of a bubble in the stock and property markets. A scenario in which the price of stocks or real estate is rising steeply while the underlying profits of companies or rental income on real estate is not rising as much (or even falling), will result in high valuation multiples on the assets. These multiples are not “justified”, and therefore suggest that a correction may be on the horizon.

High investment leverage

A persistent rise in debt-financed investments in the stock market (i.e. margin positions) will typically fuel the amount of liquidity in the market, hence the tendency for stock prices to be pushed up faster than the growth in the underlying profits of companies due to the stronger demand. Therefore, investors should be weary when they begin to see a rising trend in debt/market capitalization ratio.

Aggressive appetite for new issues

Although an increase in primary market activities is normally associated with a rising market that is supported by strong fundamentals, a glut of new issues, whether debt or equity, definitely calls for caution. Additional red flags in this area will include a significant reduction in the time-to-market of new issues, as well as a general over-subscription of new issues in the market regardless of the difference in quality. While the former reduces the amount of time an investor has to evaluate the new issue in order to make an informed investment decision, the latter is an indication of excess liquidity in the market which beclouds optimal resource allocation decision-making.

Pricey deals

The tone of the market for corporate transactions (mergers and acquisitions) could also give some sense as to whether a bubble is being fuelled. A cycle in which companies are generally exuberant in spending in the corporate market, and are willing to break the bank to acquire desired targets, is suggestive of a bubble situation.

Oluyomi is the Portfolio Manager, FBN Capital Asset Management

In this cycle, deals are consummated at significant premiums to the historical transaction multiples on similar deals executed in the past, suggesting an overpayment for the assets and liabilities of the target company.

General/widespread euphoria:

When there is so much buzz about the financial markets that everyone feels they are in a position to give investment advice that will work, then it is probably time to dash for the door! Also, a situation in which investors seem to be getting increasingly comfortable with negative news (either at the macro or company level) is a credible pointer to a bubble-in-process. And surprisingly, investment analysts/brokers also catch the bug too as recommendations tend to overly optimistic in the build-up to a bubble. So be sure to more discerning when listening to advice from your broker! Or better still, you should consider engaging the services of a professional Fund Manager who has a firm grasp of market cycles, and is able to maximize the opportunities that they present.