Fizzy assets

Bubbles in a market can take years to form and be noticed. After technology and property, will the next assets to inflate be commodities, or even equities? Vanessa Drucker, in New York, explains how bubbles develop and attempts to read the signs.

“The problem is, that since [commodities] do not pay dividends, one must constantly buy them at higher prices,” says Dufour. “Moreover, since they all serve different purposes, it makes no sense to short them all at once.”

In fact, difficulties in shorting any given asset class may help to promote bubbles. For instance, housing is almost impossible to short (assuming that renting is usually too cumbersome a solution), and one of the reasons structured products initially gained undue steam was the challenge of shorting, before standardised instruments were created.

Silver attracted widespread attention as a bubble candidate leading up to its recent correction in May, after its price trebled from September 2010. In Shanghai alone, on the main Chinese metals exchange, silver turnover rose 2,837% from the beginning of the year, with the number of contracts doubling over the period.

What lifted the metal, which backs no currencies, and is easier to find than gold? The move appears in large part to have been propelled by investors’ purchases of the exchange-traded fund, which gained popularity both as a “poor man’s gold”, and as a form of diversification from the yellow metal.

Gold, too, has soared, albeit at a less headlong rate, doubling from about $720 per ounce in November 2008 to about $1,500 per ounce today. The fundamentals do not remotely justify the rise, with industrial and jewellery demand growth creeping at 2% a year versus supply growth. It makes less sense, however, to talk about gold’s becoming unmoored from intrinsic value, as gold does not have definable intrinsic value.

According to Roda, gold “is shiny and it is scarce and universally accepted as something of value, but the perceived value is largely politically driven”.

Like other commodities, gold has a long history of cyclicality. “Those who bought gold in 1973 paid approximately $106,” says Stephen Todd Walker, a managing director at Oppenheimer Investments. He recounts that “by 1979, gold prices were around $459, more than a fourfold increase over six years.

“Just like today, gold was a hot topic and investors wondered whether or not to jump in, wait, or take a pass.”

In fact, gold did continue its climb, cresting in 1981 at $594, after which a reversal set in. By 2001 the price of the metal was floundering at $271. “Those who jumped in at the high ground lost more than 50% over this time period,” says Walker.

A more telling question is whether equities are at the threshold of bubble territory. The class comprises a much greater share of investors’ portfolios than commodities or other alternatives do. “It has been the policy of the Federal Reserve to take risk equities above intrinsic value, which Ben Bernanke [the Fed chairman] has stated quite openly,” says Andres, referring to an apparent policy and ploy to manipulate the wealth effect.

On August 27, 2010, Bernanke’s speech in Jackson Hole paved the way for further quantitative easing (QE2), after which global markets roared out of the gate. An often quoted phrase was expressed, not by Bernanke, but by Brian Sack, the manager of the System Open Market Account for the New York Fed, at a chartered financial analysts’ fixed income conference on October 4: “Balance sheet policy can still lower longer-term borrowing costs for many households and businesses and it adds to household wealth by keeping asset prices higher than they otherwise would be.”

Yet a powerful initial shove predated the launch of QE2. On March 9, 2006, when the S&P index touched 666, President Obama used the bully pulpit and it worked like a charm. “Obama, who knows nothing about markets, said, ’I think everyone should invest in equities’,” says Graves of Renaissance Group. “Groups like Goldman Sachs were the first to jump in, which helped attract others.”

Whether equity markets have become overpriced is controversial. Some argue that they have not, like Professor Robert Shiller of Yale University, who attributes the rebound more to an expression of relief as exaggerated fears of depression have receded.

Others are fearful that stocks have become extremely expensive. Mike Martin, the president of Financial Advantage, an advisory firm in Columbia, Maryland, points to several key indicators to suggest equities are expensive. He referers to Shiller’s own cyclically-adjusted price/ earnings ratio (CAPE) formula, which use­s the normal price-to-earnings numerator but smoothes out the denominator earnings over a 10-year average to adjust for the volatility of the business cycle. The Shiller CAPE is running at about 23 times, which is 44% over its 100-year mean of 16 times. Martin notes: “The only two periods during the last 130 years that this valuation was higher were just prior to the 1929 crash and during the era of the dotcom boom.”

For further ammunition, Martin highlights the S&P dividend yield, which has historically accounted for over half of total returns for stocks and stands at just 1.8%. The only time it has ever been lower was at the peak of the dotcom bubble. “In other words, expectations for growth have never been higher,” Martin explains. In addition, the “Q Ratio”, which measures price to replacement cost for corporate assets, is 60% above its long-term mean ratio; it is therefore higher than at any time in the past 130 years, except during the 1998-2000 dotcom bubble.

”The problem is that since commodities do not pay dividends one must constantly buy them at higher prices”

Smaller bubbles can simmer merrily too. Commercial real estate, especially properties with high-credit tenants in some larger cities, may be heading for the heights – again. The culprits come from two directions: banks and investors. Troubled banks are being forced to “extend and pretend” their commercial real estate portfolios because the losses they would occur upon divestiture are larger than the total capitalisation of the banks.

“Thus, without extend and pretend, these small troubled banks are insolvent,” says Marc Mattox of Southwest Strata Investment Group in Dallas, Texas. After the collapse of the real estate finance market in 2007, private equity funds began raising opportunistic capital for distressed assets, with a limited time horizon to invest. In their race to deploy that capital fast enough, they are driving prices towards the peak levels of 2006. “It’s not uncommon to have over 40 bidders for trophy properties,” reports Mattox.

Even some more obscure alternative assets may be ripe for speculation. Shiller has marked farmland as the next prospective bubble, in America and Britain. It fits neatly into the finite scarcity category, like gold, and also ties into the popular narratives for global warming and food shortages.

If bubbles are difficult to identify early, and dangerous to ride as they grow, investors must take protective steps. Warning signs that may point to a deflating bubble include high volatility or a steep daily percentage drop. “A sudden drop of 5% to 10% represents a medium signal, and over 10% is a red signal to sell right away,” Dufour advises. Even while such warning signs are flashing, investors often hold positions and double down, convinced the price will climb back up.

Various strategies can add protection. It is prudent to safeguard positions by using stop loss or tracking orders; to consider going flat, entirely into cash; or to take profits along the way to rebalance portfolios regularly.

Where to set stops is an art form, to avoid getting whipsawed with volatility. Dufour routinely places them 7% below his entry point when he purchases an asset, and then tracks its price carefully. Stephen Solaka, the managing partner of Los Angeles-based Belmont Capital Group, adds a recommendation for option collar strategies. By purchasing a put option, one can simultaneously use the proceeds from the premium to sell a call option on the same position, for effectively no cost. The strike prices can be set at any given distance, whe­ther 2%, 5%, 10% or even 20% wide. “Since many bubbles persist, it’s a good way for the leery to retain exposure,” says Solaka.

Bubbles may endure for months or years, but in the end, they do go pop. Once they start to deflate, the plunge can be dramatic, tumbling deep into undervalued territory, with fallout effects across the economy. Investors should beware of following the momentum, especially with leverage. However euphoric the ride up, however compelling the narrative – from a Chinese housing boom to hungry mouths in emerging markets, to new meteorological eras or dynamic innovations like credit default swaps or social networking models – the journey back down to reality can be brutal.