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The 5 Sure Signs of an Asset Bubble

Published by Hamilton Software, Inc. on June 20, 2015 | Comments

Tech, real estate, gold? How do I know whether the hottest sector fund in my portfolio is a great investment or simply in a bubble that’s about to burst? When so many investors are deceived, as they were during the huge tech rally of the late 90s or the recent real estate implosion, how can I spot the next bubble, and could I be invested in it already?

Ironically, the key indications that an asset is in a price bubble are the very reasons people buy the asset. We are so emotionally lured that we actually ignore warning signs staring us in the face. We must recognize that what’s drawing us into an investment may be exactly the reason to avoid it… a difficult exercise in self-discipline, but usually not hard detective work.

1  An Abnormally Long Rally
The first and always controversial indication is a sustained rally that violates the historically normal trends and cyclical patterns for the asset. This is a subtle and ambiguous clue at first, but becomes more obvious with time. The asset is obviously on a roll, but is that really bad? Is the asset just underpriced? Is there a fundamental change in the market?

Technical indicators can reveal when prices have remained outside a normal range for an abnormally long time, but by the time the asset is unambiguously in a bubble, it is usually clearly visible on a long-term chart. “Long-term” must be long enough to fully encompass the bubble and long enough to show normal patterns. This typically means several decades, not just a few years.

2  Experts Begin Rationalizing
When a normal correction fails to materialize after repeated predictions, analysts offering clever explanations will be sought for their wisdom. The longer the rally violates traditional expectations, the less interested investors are in hearing traditional logic that now appears to be wrong. As public attention turns to “experts” who can reassure investors with novel arguments that they have nothing to fear but wealth itself, eventually, the entire investor establishment is compelled to tout an alternative view… that times have changed and ordinary rules no longer apply. “Everything’s different this time.”

During the tech bubble of 1999, as investors scrambled to buy new companies with no earnings (and therefore infinitely high P/E ratios), analysts began claiming traditional P/E ratios were old fashioned and obsolete in the new environment. Companies that literally had no measurable business activity saw their share prices soar as analysts rated them on P/G (price-to-growth) ratio, the new, modern measurement specifically concocted to rationalize the absurd. When you start hearing “everything’s different this time, old rules don’t apply”, sell.

3  Ignorant Jump On Board
The third clear indication of an asset bubble occurs when the asset is accumulated by those who are inexperienced, uninformed or unqualified to be investing in anything more sophisticated than a 401k. Your brother-in-law, who knows nothing about investing, suddenly regards himself an authority on this particular asset. After all, he’s making lots of money by owning it.

Remember the E-Trade ads in which the tow-truck driver showed a photo of his island to the Wall Street executive, or the impetuous youngster dispensing trading advice to his fiancé’s father? When masses of ignorant amateurs who’ve convinced themselves they’re brilliant become the primary buyers of the asset, you have one of the clearest and worst signs of impending disaster.

4  Advertising
A very obvious indication is when the asset’s popularity makes it the subject of ad campaigns. This occurred extensively during the tech bubble, as the public witnessed bizarre ads for upstart internet-based stock symbols that offered no description of the company’s line of business, or the non-stop stream of ads for online brokerages, where one could immediately begin day-trading like a pro. It happened again during the housing bubble as ads for Ditech and Lending Tree punctuated TV shows with titles like "Curb Appeal" and “Flip This House”. And now it’s happening on a daily basis with gold and silver.

A good rule of thumb is to never invest in an asset that’s being advertised. Advertising inflates price by pumping up demand. When the asset loses mass appeal, the advertisers will go away, letting the air out of the inflated price. You can always be sure the price of something is higher than it’s really worth if it’s being advertised.

5  Denial
Once a bubble has become clearly obvious but still refuses to burst, euphoric investors take this as yet another sign they’re on a safe path to unlimited wealth. They reason that it can't be a bubble if it's gone on this long. Those who admit it’s a bubble remain unconcerned since they naively plan to sell when things start to go down.

Bubbles tend to burst suddenly, with an initial massive selloff that occurs sharply over one or two days. Inexperienced investors, who spent months or even years watching the price go up, are taken completely by surprise when this happens and are convinced it’s a fluke. The smart people get out quickly, but the fools hang on in complete denial. They’ve bought into the false explanations and believe in their own expertise. They’re in a state of shock from watching their wealth disappear overnight and are embarrassed to admit they’re the fools.

Occasionally there will be a bounce, as there was in December of 1929 or the summer of 2000. But don’t be deceived. If the bubble criteria have been met, you can be sure such a shadow rally is the futile attempt of millions in denial trying desperately to keep the party going. It’s your last good opportunity to sell, and eventually everyone else will realize that.


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