Over the past few days, we’ve been addressing the following question posed to us by one of our blog’s readers.
“We had the tech bubble – marked by people buying stocks that had no earnings. We had a housing bubble – marked by the subprime debacle. My question is where is the next bubble, how can I play it in the initial phase to benefit from its formation and what would the signals be going forward that would alert me to the fact that it’s time to lighten up?”
Last Wednesday, we provided our philosophical view of the question itself and we tried to define what an investment bubble is. On Thursday, we identified two areas that while not bubbles today, enjoy characteristics that could make them so in the future. Today, we will attempt to address the signals that might alert one to the fact that it’s time to lighten up.
Valuations
During the technology boom, valuations became stretched — obscenely so. While triple digit p/e ratios might have been justified by the triple digit growth rates that existed at the time, these high rates of growth didn’t sustain themselves. In fact, they didn’t last much longer than six months and shortly thereafter turned negative.
On the flip side, valuations don’t always alert you that the end is near or that a bubble even exists. In the recent housing bubble, p/e ratios were rarely higher than the market’s multiple, hovering around 10-12x earnings. While there was an earnings bubble in the sector, one couldn’t tell by looking at the p/e ratio alone.
Valuations, while offering clues, aren’t a foolproof answer. One should also keep in mind that some of the best performing growth companies often carry higher than average multiples for significant periods of time. Extreme valuations on entire sectors, however, may warrant greater caution.
Torrid Money Flows, Eye Popping Performance
Torrid money flows into a single investment theme and eye popping performance for long periods of time may signal that a bubble is getting long in the tooth. Unfortunately, most individual investors don’t have access to this type of data and human nature more often than not encourages most folks to buy at the tops rather than sell. And to be fair, industry insiders don’t have a very good record of calling the tops or protecting themselves either, even though they have access to far more data than the rest of us.
Media Coverage and Greed
In an update we published in May titled A Narrower Market, we noted that the private equity industry seemed to be nearing the peak of a feeding frenzy. Extensive media coverage, out sized returns, and occasional over the top displays of personal wealth were important cautionary signals. A theme of growth through acquisition seemed at odds with a history of growth based on invention. The credit markets soon imploded and the private equity market has since come to a standstill. Many high profile hedge funds declined thirty percent or more.
Concluding Comments
The evidence suggests that if you’re an active participant in the upside of a bubble, you’re less likely to notice that you’re approaching the end. You’ll likely be blindsided by something you won’t recognize as greed, but will nevertheless have all the trimmings. You may also seek out and listen to illogical justifications for why it’s different this time.
On the other hand, if you’re not a participant in the upside of a bubble, you may more readily foresee its end, but also be confused by feelings of jealousy and sour grapes. And in any event, unless you go short, your position won’t mean much for you financially.
Today, the international markets and the mobile internet represent two themes with tremendous long term investor appeal. They aren’t bubbles yet, but have the potential to become so. I’d recommend paying attention to valuations, media attention, fund flows, and greed as signs that you might be overstaying your investment. On the international front, keeping an eye on politics and free market trends will likely be VERY imporant as well.
But let’s be honest. Very, very few win at this game. While it looks great on paper, it rarely holds up in reality. As we said on day one, I like the idea of seeking out and participating in future investment bubbles, but only at a level at which the emotions of fear and greed are held at bay. If they’re not, you need to diversify.