Discerning readers may already have identified the image in this post as A Satire of Tulip Mania by Jan Brueghel. The Tulip Mania, said to have occurred in 1637, could well have been the first ever asset bubble in the history of mankind. At the peak of the mania, tulip bulbs reportedly sold for ten times the annual salary of a skilled craftsmen. Look closely and you will notice the artist's depiction of the subsequent collapse in tulip prices and its impact on investors - A few monkeys are shown in a debtor's court and one is being carried to its grave. The history of financial markets have been littered with numerous examples of Asset Bubbles. Japanese Equities in the 80's. The Dot Com bubble. The Latin American crisis in 2001-02. And, more recently, in 2008, the housing market crisis in the United States.
The slew of crises through time suggest that assets bubbles are inevitable. There aren't any definite indicators or predictive models in place to identify one (If there were any, then we would never have had any in the first place). I believe though there are a few tell-tale signs that might indicate that you are in the midst of one.
The Non Traditional Buyer
One of the very first signs of a possible bubble in any asset class is when a Non Traditional Buyer shows interest in an asset class that he or she had until then completely shunned. I remember speaking to a leading jeweler in September 2011 and asking him whether he thought that the bullish forecasts on Gold had substance (Spot Gold was then trading at $1920/ounce and most forecasts predicted a $2000/ounce in 2012). The jeweler considered the question carefully , shook his head slowly and said, "I don't know". He then said, "For the very first time in my thirty-three year career as a jeweler, I have seen Western Expatriates walk into my stores in large numbers and buy significant amounts of gold and that puzzles me".
Not surprisingly, Gold retreated significantly after that.
This is very similar to how the Chinese Middle Class approached Copper as an Investment Asset in 2007. Those were the hey days of Copper and while difficult to imagine, what happened was this - Chinese Middle Class households bought copper vessels overnight (even when they did not need it) and then checked if copper prices had moved up in the market the next day!
Momentum trumps Value
Bubbles also tend to be characterized by a gradual shift in the approach to Asset Valuation. Traditional Relative Value indicators like a Price-to-Earnings or a Enterprise-to-EBITDA ratio are relegated to the background. The focus intensifies on the Momentum Indicators - 52 week high-lows and the Moving Averages, for instance. Not surprisingly, this stage is also characterized by corporate statements that are best described as flippant - A simple "We are growing" statement is enough to push their stock into the orbit. Ever wondered why, during a certain phase of the financial markets, the Walmart stock in your portfolio remained staid while the Casino Stocks that the Jones' invested into quadrupled in a short span of time? You haven't got it wrong. That's just momentum at work.
This is a simple one. You sense you are in bubble territory when you get into a cab and at the end of your ride, your cabbie, a grizzled man well into his winter years, turns around and asks you, "Which stock do you think I need to put my money into?"
You are completely nonplussed for a couple of seconds. Its tough for you to understand how this investor (who, considering his life-stage, should have been extremely risk-averse) could have leap-frogged to the other extreme of the risk spectrum - Into a space that can best be described as the realm of speculators.
The possibility that you are in the midst of a bubble isn't because he asked you that specific question.
Its because you knew you did not have an answer.
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