16 ways to spot a bubble

1st September 2010

'House prices have nowhere to go but down' screams the headline in The Guardian. And it's not alone with its property sector pessimism. According to the property website Rightmove.co.uk, only 22% of potential buyers are considering buying their first property in the next year, that compares with 31% the same time last year.

But that's only half the story, first-time buyers currently account for just 20% of the market, and that's about half the level needed to oil the housing chain. A factor that's also been picked up by The Motley Fool's community

Back on the property pessimism board, The Motley Fool's mrgreedy2 sounds world-weary, saying:  "Show me one bubble in history that didn't go pop."

More worryingly talk turns to a comparion with Japan. The Fool's apdavidson says: "The UK is behaving like Japan in the early 1990s. The young who haven't got the support of parents, our equivalent of their 2 generation mortgages, can't save the 20%+ deposit the banks insist upon. So, outside of London, the market is slumping.

"Also as happened in Japan, the developers are tying (sic) to maintain their oligopolistic control of development land prices. That can only continue so long as the interest rates they pay remain low because of government pump priming."

Henderson's Simon Ward says UK house prices are 6% overvalued, based on a comparison of the national rental yield with its historical average, but he doesn't see a fall in prices as inevitable.

"First, the deviation can be corrected by rising rents – up by 7% in the year to the first quarter. Secondly, a below-average rental yield may be sustainable as long as nominal and real interest rates remain low, limiting forced selling."

But seeing as bubbles can be created – and burst – by market sentiment, where does that leave us?  Is the property bubble about to burst? Or has the air started leaking out slowly?

Greed and fear

After the TMT situation and, more recently, similar rises and falls in areas like property, the word bubble has become pejorative in the extreme.

While assets trading vastly above their nominal value can clearly be dangerous, think about it for a moment – if someone had held tech stocks through the late 1990s and sold out in early 2000, they would have locked in enormous gains.

The problem with bubbles is that people rarely get out at the right time – and when they burst, the after-effects can be catastrophic.

15 ways to spot a bubble

An article on The Motley Fool lists 15 ways to spot a bubble, including the increased leverage and product complexity largely seen as responsible for the credit crunch.

One commentator adds a 16th signal, "New methods of valuation are created to justify crazy prices.

"During the TMT boom, ISPs were valued at up to £2,000 per user, tech companies at £5 million per engineer. Houses are affordable if the loan interest is 'only' 50% of your income."

The bubble terminology goes right back to the South Sea bubble of the early 1700s, where speculation in the South Sea Company pushed up stock prices.

This situation had elements we now consider integral to an asset price bubble, even catching the attention of the period's greatest minds.

The madness of men

When asked about the situation, Sir Isaac Newton – who lost a fortune himself – is reported to have said: "I can calculate the movement of the stars, but not the madness of men."

Few economists have developed respectable models to explain asset price bubbles, with the Australian School of Economics a notable example.

Their view is that most bubbles in asset prices are caused by excess monetary and credit stimulus – which might set off a few alarm bells in the current circumstances.

In today´s economy, the Central Banks print money without any real assets to back up the currency issued.

This artificially promotes credit, which in turn fuels asset bubbles, because of excess liquidity without a pool of real savings.

Pop goes the bubble

Low interest rate policies by the US Federal Reserve in the 2001-2004 for example created housing and commodities bubbles.

These popped as soon as fed funds rates were raised to natural levels.

But if further irrational exuberance is unavoidable, the key has to lie in riding the wave to the top and then getting off before it crashes to the ground.

Investors are notoriously bad at selling well but if we do need bubbles to propel us into space (and help save our current planet), getting out at the right time will be vital to making any money from these trends – as trite as that might sound.

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