Asset Bubbles are an integral part of any traded investment: be it economic (such as a property) or financial (such as shares in a company). While there is a long history of asset bubbles and their dynamics few have tried to develop a holistic strategy to maximize value during these periods of high volatility. The classic approach is to: ‘buy low/sell high’ or be a short-trader.
The dynamics of asset bubbles have won Nobel prizes for numerous researchers (such as Schiller this year and Kahneman in 2011). Practitioners (such as Taleb) maintain that asset bubbles refelct the dynamics of ‘ant-fragility’.
Yet many market participants find it difficult to realize the potential returns associated with such dynamics. This note highlights the challenges and some possible approaches.
Context – cheap money fuelling speculation
Asset bubbles have again risen to prominence in today’s volatile markets.
Government sponsored debt is fueling the recovery of stock market exchanges as well as property markets. For example the Dow Jones Industrial Average reaches an all-time high of 16,000 last week. There have been accelerated and spectacular gyrations of share price for certain listed companies and their sectors as of late (i.e., the 3D Printing and Gaming sectors). A recent Bloomberg poll of analysts and traders showed that 82% of respondents felt that Internet and Social media stocks were near or at a bubble level. Similar poll results have been recorded for property prices worldwide: in Shanghai and London.
In a bubble, the price of an asset class maintains an implausibly high value. It is a phenomenon of lasting overvaluation. Simply put an “asset bubble” is any substantial upward price movement over an extended range that suddenly implodes. This state is a deviation from market value; where the price of an asset should reflect the present value of its future cash flow. A bubble forms because the purchase price of the asset is made not necessarily based on the rate of return on the investment, but in anticipation that the asset can be sold to a “greater fool” at an even higher price. The “fundamentals”—i.e., the present value of its discounted expected future cash flows – are ignored.
These symptoms speak to the notion of valuation, communication and behavioral economics. They provide opportunities for arbitrage and above average returns to the experienced investor. Certainly for those investors that feel compelled to sell at a loss perhaps the “fool” moniker is correct. They become hostage to an innate, deep-seated personal loathing of a loss and overreact to try and compensate or reduce the fear.
Economic theory being challenged
This observed behavior neatly summarizes the academic debate and provides the basis for developing a more robust, and rewarding approach, to investing through bubbles
For the last 50 years ‘Efficient Market’ theory has been predicted on the dual assumptions of: perfect markets and rational participants – the basis of ‘economic man’. This theory has been challenged by the simplicity of its own assumptions and observed reality. It is being replaced by the tenets of behavioral finance.
Behavioral Finance’s underlying belief is “bounded rationality”, where decision processes can shape decision outcomes. Suboptimal decisions are caused by a combination of: cognition, emotions and conformism. Researches have reduced the process of how people think and decide into two essential elements:
- Mental maps: During a bubble, impressions and intuition overwhelm experience and logic.
- Heuristics: These are our personal short-hands to make decisions: be they (what have been termed) “slow” and “fast” thinking decisions. Representativeness, availability as well as anchoring & adjustment can lessen the objectivity of such short-hands during a bubble.
Empirical studies reveal how this behavioral dynamic can consistently reduce value maximization if not leading to ongoing loss.
Taleb states that asset bubbles are a natural expression of randomness and forces that influence anti-fragility. For him asset bubbles are a fool’s game. His warning is for the observers to interpret the dynamic carefully and act accordingly.
Analysis of the recommendations of security analysts’ recommendations and forecasts against reality reveal a statistically valid failure rate. In short: even the professionals are not immune to bubble mania.
How a bubble’s form reveals these changes in behavior
There is now a well-established profile of a bubble.
The bubble curve clearly captures the changing behaviors of investors across the dimensions of valuation (or asset price) and time.
Asset bubble profile:
It is a surprisingly robust model.
Gartner have gone a step further. It has extrapolated the pattern into a “Hype Curve” which can be discerned for nearly any decision (be it valuations for Social Media stocks and even relationships- as shown below).
Gartner Hype Curves:
In reality the model can describe as well as be used as a predictive tool.
Models reflect and can predict
In theory a bubble’s rate of growth can last indefinitely if it matches the discount rate. There are some tell-tale signs that a more aware investor needs to recognize
- The fundamental valuation principles of the asset seem to be absent or suspended. The asset’s price persistently exceeds other measures of valuation: essentially the present value of future cash flows
- Professional investors start to copy each other’s behaviors – “herd tendencies” start to prevail.
- Sudden appearance of inexperienced investors (so-called “Hot Money|
- Increasing volumes, volatility and churn.
- Stock movements having little correlation to discernible events or information (for example ‘trading on expectation and selling on the news’
- Trading ratios reveal increasingly high volumes, churn and shortening holding periods.
- Professionals have limited liability and therefore bear little risk for any loss.
In fact one can find many post-fact examples from stock markets that fit the curve. The example of Raisio over a six year period reveals a fit.
Raisio share price and Bubble curve (1996-2003):
How to consider investment strategies
By boiling down the curves into one that captures participant emotions allows one to identify a “peak of financial risk” and a “trough of financial opportunity”. This profile helps explain the old investment adage of: ‘buy low, sell high’.
While the graphics hold a certain fascination what are the tangible implications for an investor?
Current academic thinking (derived from observed precedents) suggests that asset bubbles are a natural process of allocation. It shifts funds from the less capable investors (often panic stricken retail investors) to more capable ones (higher net worth and more professionally organized) as asset prices are set. The latter are able to see through the so-called Hype Curve to the sustainable value and trade through the peaks and troughs of price.
- Value investors search for undervalued assets. In contrast short sellers search the market for over value stocks. Their activities lead to gyrations.
- While short-sellers’ relative costs and risks are higher the potential returns are significant and can provide significant rewards. A situation fuelled by access to cheap credit and the effects of program trading
Essentially there are three ways to participate profitably in a bubble.
- Abstain. Just don’t participate. One needs to understand what is going on but remain on the sides line
- Adopt a ‘short-seller” mentality. This call/carry-trade/margin investing requires relatively high level of financing as well as great deal of active attention. The former allows one to pick the inflection points on the curve. The latter allows one to fund the probability of many losses but a few relatively large successes.
- Enter after the bubble has fully deflated, at the long term floor.
- (Trying to play on the bubble curve’s initial upswing is feasible. Yet the probabilities, skills and resources required make this approach sustainably rewarding is prohibitive but to all but a few investors).
However for a number of investors there is more than just the financial reward; the emotional adrenalin rush is as much a return as the money The above four strategies are rationale and assume that the investor is accountable for funds at stake – in the sense that he/she suffers the loss. In reality behavioral finance and empirical evidence reveals that a number of retail investors derive an emotional value from the adrenalin rush of such volatility and uncertain outcomes. It is another form of speculation and gambling.
A worked example: 3-D Printing
The predictive qualities of the curve can be very powerful as displayed by the recent dynamics in the 3-D Printing market. Picking an asset bubble is relatively easy.
- Models and tracking systems can be relatively easily developed that will alert one to any share price deviations that display above average growth, particularly in a short time period. A stock that enjoys more than 5% growth within a month is at the initial period of bubble development. As the bubble develops, a 5-10% variation within a day is not uncommon. For smaller valued companies the pattern is exaggerated.
- Once identified, an objective assessment should be made of the underlying company. The riskiest bubble stocks are associated with smaller companies in a new sector, usually technology related.
- Set out an acceptable goal and return level: 10, 20, 50% and over what time period? Be specific about the rational for each company with target entry and exit price and timing.
- Stick to the rational unless new relevant information becomes available.
- Take home a portion of any profits upon exist, if one intends to conduct multiple investments in the same stock.
A worked example gives one an idea of how one might successfully participate in asset bubbles.
Recently, the 3-D printing segment has displayed all the hallmarks of a bubble as described above. The six main US listed companies have enjoyed an average growth of over 500%. Some as high as 900%! The recent development of Arcam, a Swedish based 3-D printing company, reveals how this bubble pattern can be compressed into months and used by a pro-active.
Arcam has enjoyed increasing positive performance, unusual in the industry with revenue growth and profits. The presence of private equity and an increasing order book and dual listing (home in Stockholm and ADR in New York) have helped fuel frenzy. At its peak Arcam had a P/E ratio of close to 140x. For the last 12 months, Arcam has increased its share price by 656% (at its peak in mid-November it represented a near 977%). Clssical analyses (net present value, ratios, replacemetn value etc) will suggets that as of Novemenbr 2013 Arcam’s valuation should be between sek 600 and 750 per share. It currently trades around the SEK 1000 mark.
Arcam share price development (AMAVF): last twelve months:
For Voxeljet, another 3-D printer, its share price development reveals a similar pattern, but over the initial 10 day period after its IPO on 22 October 2013.
Returns are all dependent upon timing and how one secures profits. If one is churning then taking 30-50% of the profit provides a base level performance. A typical day-trader portfolio from the period 24 June to 17 November 2013 has managed to capture a return of 64% through four distinct investments (end June, August, early October, November). The notional profit was stripped out before reinvesting the same amount of principal. This credible result pales when compared to the arithmetic increase of 254% for having the foresight and conviction of a buy & hold strategy through the same period. A committed short-seller would probably have made closer to 100% return. The late in the bubble, retail investor probably panicked and would have suffered losses of 10-50%. (Notice the sharp increase in volumes during the troughs: mid-September, mid-November).
What does this reveal?
- If one is early enough in the bubble formation a ‘buy & hold’ strategy would seem to be best
- Churning requires time, incurs costs and can lessen returns, although it may provide peace of mind at the time.
- A committed short-seller could improve his/her returns but at a cost of money, time and emotion.
- The ill-informed and emotionally driven day-trader will suffer a loss.
So where are the next bubbles?
The siren calls form professionals and observes is that the world’s stock markets are overheated and at the cusp of a bubble implosion. With major stocks such as Google and others enjoying a +48% increase in share price during the last twelve months and Apple’s gyrations suggest bubble characteristics.
If the 3-D Printing wave continues then the “ink’ suppliers (such as graphene) will be due for an abnormal increase. Bitcoins continue to display all the hall marks of a bubble; but at what stage?
Asset bubbles are an integral part of our financial world. Recognizing them for what they are is the first step in taking advantage of them. Returns for some of the informed investor can be double even triple digit; many though will suffer a loss.