Jan 28 2014, 8:32pm CST | by Forbes
If you ask Warren Buffett, Marc Faber, Bob Doll, Carl Icahn, and a host of others if the U.S. stock market is in a bubble, you’re likely to get answers that lean toward, “Yes.” Most of us have heard of financial bubbles. However, have you noticed they have been occurring with greater frequency? What causes bubbles? How do you know when a bubble is present? Finally, as an investor, what should you do if stocks are in a bubble today? In this article, we’ll examine these vitally important questions, glean advice from experts, and shed some light on this issue.
What Causes Bubbles?
With the benefit of hindsight, we can examine past bubbles and learn a great deal. One of the earliest, if not the first, recorded bubble involved tulip bulbs. Here’s how the story unfolded. Tulips originated in the Iberian Peninsula (Spain and Portugal) and North Africa. The University of Leiden, in The Netherlands, hired Flemish botanist Carolus Clusius who established a botanical garden in 1593. The newly hired professor planted his collection of tulip bulbs in what is now the oldest botanical garden in The Netherlands and one of the oldest in the world. The tulip began to increase in popularity as it was distinctively different from all other flowers. Then the story took an interesting turn. Many bulbs contracted the mosaic virus which caused a variegation in the tulips’ petals, giving them the appearance of a flame. This alteration made the flower even more coveted which caused prices to rise to the point where people began to view the tulip more as an investment than an adornment. Everyone from nobility down to the chimney sweep dabbled in tulips. Moreover, the belief that prices would continue to climb became the new paradigm. While skeptics sat on the sideline, their friends and neighbors made handsome profits speculating on the bulbs. Call options were even created which allowed investors to pay a small fee for the right to buy tulip bulbs at a designated price within a specified time frame. As speculation increased, prices soared and, in the final years of tulip mania (1634-37), people were hocking land, jewelry, and just about everything else to buy these amazing bulbs. Greed was rampant as everyone believed this was the way to become wealthy.
One day a sailor returned to Holland bringing good news to a local merchant that a shipment of goods had arrived. The merchant was so pleased that he rewarded the sailor with a free breakfast. As the sailor sat eating, he noticed what he thought was an onion sitting on the counter nearby. The sailor used the ‘onion’ to enhance the flavor of his breakfast. However, it was not an onion at all. Rather, it was a rare Semper Augustus tulip bulb. This bulb was so valuable that, if it were sold, the proceeds from the sale could have fed the entire crew of his ship for full year. What became of this sailor? He was arrested on a felony charge and spent several months in jail. But there’s more to this story.
When Bubbles Burst
What causes a bubble to burst? In the case of the tulip, which is the typical bubble-bursting process, people began to sell their bulbs and take profits. As more and more investors sold, panic-selling began and prices literally collapsed. The decline was swift and steep. In fact, despite the government’s best efforts to calm investors, the “boom to bust” shock was so great, and so widespread, that it was followed by an extended depression in Holland. Hence, bubbles are caused by speculation, excessive demand, mania, greed, etc., and they burst when investors take profits.
What Are The Stages Of A Bubble?
According to Dr. Jean-Paul Rodrigue of Hofstra University, bubbles go through stages. The following graph illustrates the primary stages of a bubble. Stage One is the Stealth Phase, when the “smart money” enters. Stage Two is the Awareness Phase, when institutions begin to invest. Stage Three is the Mania Phase, when the media broadcasts it to the general public who, in turn, begin to invest. It is during this phase that speculation rises, investors buy on margin, and prices soar. At the peak of this stage a new paradigm emerges. The paradigm is that prices will always rise, which is reinforced by a surge of excess and superfluous optimism.
The top of Stage Three looks a lot like October 1929, February 2000, and October 2007, which were all stock market peaks. It also resembles today’s market. Although, we don’t find the rampant speculation that typically exists in the Mania Phase, in its place we have a Fed who is injecting a massive amount of liquidity into a system which was severely damaged by the 2008 housing crisis. The largest beneficiary of this ‘stimulus’ is believed to be the stock market. Therefore, although this “bubble” has a slightly different character, it may be a bubble nonetheless.
The following chart shows the Dow Jones stock market from 1982 to 2014, including two confirmed bubbles (2000 and 2007) and a possible third bubble today. In the tech and housing bubbles, take special note of how prices rose sharply just before the peak.
The Federal Reserve is considered to be the quintessential bubble manufacturer of modern-day finance. This greenback-generating, massive-monetary-expanding machine, has added an enormous amount of liquidity to the system over the past several years. This, many believe, has been the chief catalyst for the meteoric rise in U.S. stocks. Are we in a bubble today?
How Do You Know When You Are In A Bubble?
During the housing bubble, the ratio between median home prices and median income expanded substantially. Historically, this ratio hovered around 3:1. To explain, if a new home cost $90,000, then median income was around $30,000. However, at the height of the housing bubble, this ratio had expanded to 4.8:1. Why? Home prices had risen much faster than income resulting in a bubble. Today, there are many experts proclaiming that we are in a bubble or, at the very least, stocks are “bubble-like.”
In July 2013, Brian Kelly of CNBC reported that the “total-market-cap to GDP ratio,” an indicator Warren Buffett uses to gauge markets, was at an all-time high of 118%. He further stated that this ratio had only hit the 100% level twice before. The first time was in 1999 and the last was in 2007. Both times were at stock market peaks! (To view this 3:28 minute video, Click Here) Mr. Buffett’s not alone. Marc Faber, a well-known economist, during a January 14, 2014 interview on Bloomberg-TV, said, “We are in a gigantic financial bubble.” (To view this 0:57 minute interview, Click Here) Is the U.S. stock market in a bubble? Only time will tell. But by the time we know for sure, it will be too late for many investors. For the sake of discussion, let’s assume we are in a bubble. As an investor what should you do?
How To Invest During A Bubble?
There are a few investment strategies you can utilize during a bubble. First, you could go to cash and wait for stocks to drop before buying. However, it is impossible to know how long you would have to wait. Next, you could buy put options to protect your stock positions. However, you would have to pay the cost of the option premium. Additionally, you could buy an annuity which limits your downside risk, but you would have to surrender some of your upside, and there may be a cost for this. Finally, here’s the method I prefer. It does limit your downside, but it does so without limiting your potential gain. Buy stock ETFs on the dips and use trailing stop orders to protect the downside. A stop order is an order to sell at a predetermined price or at some percentage below your original purchase price. Assume you bought an ETF at $10.00 per share and placed a 5.0% stop on it. 5.0% below $10.00 would be $9.50. Therefore, if the price fell to $9.50, the ETF would sell and you would have limited your loss to roughly 5.0%. A “trailing” stop order follows the price higher, maintaining a 5.0% margin. Therefore, if the price of the ETF rose to $15.00, the stop would rise to $14.25 (5.0% below the $15.00 price). Then, if the price fell, you would have a profit of approximately $4.25 ($14.25 – $10.00). I’ve been doing this for a while, and today most of my stops are well above the original purchase price. This is a wonderful strategy to help provide peace of mind.
Is this a bubble or not? Many noteworthy investors believe it is. The difficulty is knowing when the correction will come. The longer we continue down this path, the larger the bubble will grow and the worse the correction will be when it does arrive. Therefore, just as you wouldn’t jump out of an airplane without a parachute, be careful investing in stocks without protection. Many investors learned a hard lesson in the crash of 2008. When investing in stocks, play it safe and remember to pull out all the stops…trailing stops, that is!
Source: Forbes Business
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