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24-07-2011, 08:16 AM
Jul 24, 2011
small change
Spotting the hot air in a bubble
Investors may see one only when it bursts but clues can help one get out in time
By Chris Firth
Craziest financial bubble of the last 20 years? There are many 'worthy' candidates, but perhaps the winner of this title took place in China from 2005 to 2008. A basket of warrants, sure to expire worthless because of rising stock prices, were trading at prices so extreme that it was like watching a repeat of 17th century tulip mania.
The tulip bubble in Holland ran from 1634 to 1637, when a whole nation traded flower bulbs. Some estimates reckon tulip bulbs each sold for as much as US$60,000 (S$72,500) in today's money.
The China warrants bubble was especially wacky because prices of the underlying stocks allowed everyone to calculate the fair value of the warrants. In spite of this, traders were happy to pay grossly inflated prices - their only hope being to sell later before the warrants expired. Even on the last day of trading, large bets were still being made. Inevitably, some investors were left with large losses.
Speculative asset price bubbles are not new, of course. They have been observed for at least three centuries and written about as early as 1841 in a famous book called Extraordinary Popular Delusions And The Madness Of Crowds.
Examples include the precursor to the crash of Wall Street in 1929 and of Internet stocks in 1998-2000. By way of dramatic illustration, in February 2000 the average price-to-earnings ratio of 400 - mainly profitless - Internet firms exceeded a staggering 850, versus a more usual range of 10-20.
Although there are thrilling accounts of bubbles and their gory consequences, academics have a hard time explaining how bubbles work. Textbook finance assumes prices reflect fundamental values, and therefore bubbles of the type we have witnessed should not really happen.
Although the topic is still controversial, recent research suggests there are common causes. Chief among these are: investors with wildly differing initial views; 'greater fool' trading; increased leverage; and a restriction on short-selling.
If there is a subset of investors with optimistic views of a new firm's potential, then their valuations move prices up, away from the more sensible average valuation. One cause is overconfidence - a person's belief that his information is more accurate or more skilfully interpreted than that of others.
Examples from psychology indicate that overconfidence is a pervasive trait of human behaviour. A 2010 study found that financial executives were unable to make good predictions - their guesses were right only 33 per cent of the time, instead of an expected 80 per cent.
Another phenomenon is investors paying an inflated price on the expectation that a 'greater fool' will buy the asset at a higher price, as in the China warrants case. Finance experts dub this the resale option. Like share options, these are more valuable with increases in volatility, so swings in investor beliefs drive up the resale option value, inflating the bubble even more.
Speculation occurs because everyone in the market prices assets by adding an extra term to the usual formula. This is sometimes called the speculative premium, or can be thought of as the value of the resale option.
A Yale survey in 2006 confirms that many dot.com bubble investors admit to 'buying stocks they believed at the time to be over-valued, but claimed to have done so on the anticipation that the share prices would continue to rise'.
The previous two effects won't necessarily create a bubble on their own. A short-sale is a position in a security that bets on a fall in price. Professional investors, called arbitrageurs, may use short-sales when they see an over-priced asset. If arbitrageurs do a good job, the textbooks say that bubbles will never get going.
But restrictions on short-selling may prevent arbitrageurs from doing a good job. In some situations, like in the housing market, it can be practically impossible to achieve a short-sale. There are several other reasons why these pessimists may fail, at least temporarily.
Effective arbitrage may require a very long time horizon - possibly too long for most professionals. The result might be that arbitrageurs (the pessimists) jump on the bandwagon and actually join the optimists for a while. They bet that they can exit the market before the bubble pops.
Also, arbitrage needs capital. If an arbitrageur has insufficient capital to sustain a trade through adverse (but temporary) conditions, he may have to liquidate a position prematurely and the bubble survives.
A coordinated attack from the majority of arbitrageurs may deflate a bubble, but those that bet early and in small numbers may have insufficient heft, and will lose money. Hence bubbles can be temporarily sustained due to lack of coordinated attacks.
The end of a bubble can be triggered by relatively innocuous news, since the news synchronises all the arbitrageurs. This is why bubbles sometimes crash for no apparent good reason.
Some finance gurus say the most important bubble variable is the amount of leverage. The most enthusiastic buyers will pay the most for an asset, and leverage provides these investors with more cash which they invest further in the stock, driving its price up. Any margin calls or constraints on borrowing could cause the same investors to offload assets at lower prices and in exaggerated volumes.
If these same leveraged investors have positions in several markets, then shocks in one market could cause ripples in others - even though there appears to be no obvious link between the different sectors. This is known as contagion.
How can you spot a bubble? Unfortunately, there is no fail-safe method to declare a bubble exists, and we may recognise one only after it has burst. Yet there are some clues to help us.
Bubbles coincide with increases in trading volume, higher price volatility, increases in leverage and in the presence of shorting restrictions. Historically, bubbles often overlap with, or are stimulated by, technological innovations. Examples are railroads, electronics, the Web and loan securitisation.
Another sign is increasing participation of naive investors in the market. When your taxi driver starts talking about making money on condos, you can guess the property market has a bubble.
The writer is the chief executive of wealth management firm dollarDex.com
small change
Spotting the hot air in a bubble
Investors may see one only when it bursts but clues can help one get out in time
By Chris Firth
Craziest financial bubble of the last 20 years? There are many 'worthy' candidates, but perhaps the winner of this title took place in China from 2005 to 2008. A basket of warrants, sure to expire worthless because of rising stock prices, were trading at prices so extreme that it was like watching a repeat of 17th century tulip mania.
The tulip bubble in Holland ran from 1634 to 1637, when a whole nation traded flower bulbs. Some estimates reckon tulip bulbs each sold for as much as US$60,000 (S$72,500) in today's money.
The China warrants bubble was especially wacky because prices of the underlying stocks allowed everyone to calculate the fair value of the warrants. In spite of this, traders were happy to pay grossly inflated prices - their only hope being to sell later before the warrants expired. Even on the last day of trading, large bets were still being made. Inevitably, some investors were left with large losses.
Speculative asset price bubbles are not new, of course. They have been observed for at least three centuries and written about as early as 1841 in a famous book called Extraordinary Popular Delusions And The Madness Of Crowds.
Examples include the precursor to the crash of Wall Street in 1929 and of Internet stocks in 1998-2000. By way of dramatic illustration, in February 2000 the average price-to-earnings ratio of 400 - mainly profitless - Internet firms exceeded a staggering 850, versus a more usual range of 10-20.
Although there are thrilling accounts of bubbles and their gory consequences, academics have a hard time explaining how bubbles work. Textbook finance assumes prices reflect fundamental values, and therefore bubbles of the type we have witnessed should not really happen.
Although the topic is still controversial, recent research suggests there are common causes. Chief among these are: investors with wildly differing initial views; 'greater fool' trading; increased leverage; and a restriction on short-selling.
If there is a subset of investors with optimistic views of a new firm's potential, then their valuations move prices up, away from the more sensible average valuation. One cause is overconfidence - a person's belief that his information is more accurate or more skilfully interpreted than that of others.
Examples from psychology indicate that overconfidence is a pervasive trait of human behaviour. A 2010 study found that financial executives were unable to make good predictions - their guesses were right only 33 per cent of the time, instead of an expected 80 per cent.
Another phenomenon is investors paying an inflated price on the expectation that a 'greater fool' will buy the asset at a higher price, as in the China warrants case. Finance experts dub this the resale option. Like share options, these are more valuable with increases in volatility, so swings in investor beliefs drive up the resale option value, inflating the bubble even more.
Speculation occurs because everyone in the market prices assets by adding an extra term to the usual formula. This is sometimes called the speculative premium, or can be thought of as the value of the resale option.
A Yale survey in 2006 confirms that many dot.com bubble investors admit to 'buying stocks they believed at the time to be over-valued, but claimed to have done so on the anticipation that the share prices would continue to rise'.
The previous two effects won't necessarily create a bubble on their own. A short-sale is a position in a security that bets on a fall in price. Professional investors, called arbitrageurs, may use short-sales when they see an over-priced asset. If arbitrageurs do a good job, the textbooks say that bubbles will never get going.
But restrictions on short-selling may prevent arbitrageurs from doing a good job. In some situations, like in the housing market, it can be practically impossible to achieve a short-sale. There are several other reasons why these pessimists may fail, at least temporarily.
Effective arbitrage may require a very long time horizon - possibly too long for most professionals. The result might be that arbitrageurs (the pessimists) jump on the bandwagon and actually join the optimists for a while. They bet that they can exit the market before the bubble pops.
Also, arbitrage needs capital. If an arbitrageur has insufficient capital to sustain a trade through adverse (but temporary) conditions, he may have to liquidate a position prematurely and the bubble survives.
A coordinated attack from the majority of arbitrageurs may deflate a bubble, but those that bet early and in small numbers may have insufficient heft, and will lose money. Hence bubbles can be temporarily sustained due to lack of coordinated attacks.
The end of a bubble can be triggered by relatively innocuous news, since the news synchronises all the arbitrageurs. This is why bubbles sometimes crash for no apparent good reason.
Some finance gurus say the most important bubble variable is the amount of leverage. The most enthusiastic buyers will pay the most for an asset, and leverage provides these investors with more cash which they invest further in the stock, driving its price up. Any margin calls or constraints on borrowing could cause the same investors to offload assets at lower prices and in exaggerated volumes.
If these same leveraged investors have positions in several markets, then shocks in one market could cause ripples in others - even though there appears to be no obvious link between the different sectors. This is known as contagion.
How can you spot a bubble? Unfortunately, there is no fail-safe method to declare a bubble exists, and we may recognise one only after it has burst. Yet there are some clues to help us.
Bubbles coincide with increases in trading volume, higher price volatility, increases in leverage and in the presence of shorting restrictions. Historically, bubbles often overlap with, or are stimulated by, technological innovations. Examples are railroads, electronics, the Web and loan securitisation.
Another sign is increasing participation of naive investors in the market. When your taxi driver starts talking about making money on condos, you can guess the property market has a bubble.
The writer is the chief executive of wealth management firm dollarDex.com
My Value Investing Blog: http://sgmusicwhiz.blogspot.com/