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2013-12-10 06:36:56
Many investments are becoming expensive. But there is little sign of the mania
that accompanies most bubbles
TALK of bubbles is in the air again. The Dow Jones Industrial Average has hit
an all-time high. A loss-making technology firm (Twitter) has floated its
shares on a flood of investor demand. Private-equity groups are buying
companies using amounts of debt not seen since 2008. A record price (more than
$50m) has just been set for a penthouse in Manhattan. A triptych by Francis
Bacon became the most expensive piece of art sold at an auction when Christie s
flogged it for $142.4m last month. Robert Shiller of Yale University, who
correctly identified bubbles in tech stocks in the late 1990s and in property
in the 2000s, has expressed unease about giddy American share valuations.
All this suggests that wealthy investors have become increasingly confident.
The question is whether they are right to be. Under certain circumstances,
fast-rising asset prices are justified. New industries can emerge and create
corporate giants (Microsoft, Apple and Google, for example); countries can
change their economic policy and grow rapidly (Japan in the 1960s, China in the
1990s). How, then, do you tell a bull market from a bubble?
Mr Shiller describes a bubble as a psycho-economic phenomenon. It s like a
mental illness. It is marked by excessive enthusiasm, participation of the news
media and feelings of regret among people who weren t in the bubble. They are
often enlarged by an expansion of credit. But establishing an objective
definition is hard. For GMO, a fund-management group, a bubble is an increase
in the price of an asset of more than two standard deviations above the trend,
taking inflation into account.
Using that standard, GMO has identified 330 bubbles between 1720 and 2010. They
have become much more frequent in recent decades (see chart). That is partly
due to there being more markets to analyse these days. But it is probably also
a reflection of the explosion in global capital flows that followed the
collapse of the Bretton Woods system of fixed exchange rates in the early
1970s. It is hardly surprising to find that more bubbles have been inflated as
investors have rushed round the globe in search of the next big thing.
Many economists have struggled to accept that bubbles exist, as that is
difficult to square with the idea of efficient markets. If assets are obviously
overpriced, why don t smart investors take advantage and sell? Edward
Chancellor of GMO argues that investors can find it hard to arbitrage away a
bubble. Manias can last much longer than investors think, as many contrarians
discovered to their cost during the dotcom boom of the late 1990s. Nor do
investors know whether a bubble will be resolved through a sharp fall in prices
or a long period of stasis, in which inflation erodes prices in real terms
(something that happened to British houses in the 1970s).
Dimitri Vayanos and Paul Woolley of the London School of Economics have
suggested that problems of agency contribute to bubbles. Investors do not buy
shares directly but hire fund managers to do it on their behalf. They tend to
select managers who have performed well in prior years. As the managers receive
cash from new clients, they buy their favourite stocks which, by definition,
will have performed well witness the enormous sums flowing into tech funds in
the late 1990s. The favoured stocks get driven even higher.
Property bubbles also have a self-reinforcing element. Most properties are
bought with money borrowed from banks. When prices are rising, banks are more
confident about lending money; the greater availability of credit means that
borrowers can afford higher prices, and so on. Conversely, of course, when
banks become unwilling to lend more money, prices can collapse.
Many commentators believe current monetary policy may be encouraging bubbles to
form (see Free exchange). Nominal interest rates in much of the developed world
are close to zero, and central banks have been buying bonds through the policy
of quantitative easing. The intention is to reduce yields on the safest assets
and so encourage investors to buy riskier ones, reducing financing costs for
companies and boosting economic confidence through the wealth effect.
Low interest rates may also persuade some investors that risky assets are worth
more. If one lowers the rate at which future cashflows are discounted, then the
present value of an asset rises. But that is only if other things stay equal.
Central banks have adopted their current monetary policy because they worry
that the outlook for economic growth has deteriorated; if they are right, then
investors should be reducing their estimates for the cashflows they will
receive from dividends, rents, etc.
That may leave markets exposed to two risks: that the income from assets does
not rise as quickly as investors hope and that capital values decline sharply
if monetary policy changes. In its latest report on financial stability, the
Bank of England acknowledges that monetary policy has had spillover effects.
Large capital flows into emerging economies have enabled credit levels in these
countries to rise sharply, it states. Emerging markets wobbled this summer
when the Federal Reserve spoke of scaling back its monetary stimulus.
Looking back over five years, it is worth reflecting that markets have
rebounded from some huge falls in 2008 and early 2009. Investors returns over
the last 15 years have not been great. But there are a number of markets that
look overvalued on an historical basis. American equities are trading at a
cyclically-adjusted price-earnings ratio of 25, according to Mr Shiller. This
is much higher than the historic average of 16.5 but below the levels reached
in the great peaks of 1929 and 2000. Corporate profits are also at their
highest level relative to GDP since the second world war, suggesting further
growth is unlikely.
Mr Shiller is not yet ready to declare a bubble in American equities, however.
There is nothing like the same excitement about shares that was seen in the
late 1990s; net flows into mutual funds only just turned positive this year.
Another measure of public indifference is that CNBC, a television station that
tracks the financial markets, suffered its lowest ratings since 2005 in the
third quarter.
Some would put government bonds into the bubble category: last year, yields in
some markets reached the lowest levels on record. Buying bonds when yields are
less than 2% has in the past led to heavy losses. Again, however, debt markets
do not look too frothy by other measures. There is little talk at dinner
parties of the massive profits to be earned on sovereign bonds. The biggest
buyers have been central banks; there may be a problem when they try to unwind
their purchases, but that moment does not look imminent.
The Economist s house-price indicators suggest that property in New Zealand,
Canada and Australia is substantially overvalued (and GMO sees clear signs of
bubbles in British and Swedish house prices). But Hong Kong is the only
overvalued market where prices are still surging ahead by almost 20% over the
past year.
The Japanese stockmarket is up 51% so far this year (in yen terms), but that
constitutes little more than a recovery after nearly a quarter-century of
disappointment. Venezuelan equities are up more than fivefold this year (and
273% in dollar terms) but that is not a market many international investors are
excited about.
When it comes to collectables like art and fine wine, high prices may simply
reflect inequality in the developed world. Throughout history, the rich have
liked to demonstrate their status by displaying luxury goods that their
inferiors are unable to afford. An Old Master can add real va-va-voom to your
Manhattan penthouse.
The asset with a price trajectory most like a satellite launch until a slump on
December 5th is Bitcoin, an electronic currency. The news media had excitedly
chronicled its ascent. Those buying faddish financial instruments without
intrinsic value may do well to remember the adage Up like a rocket, down like
a stick.