Despite how extreme financial bubbles can be, we cannot definitely identify one until it is over. What is more, a sustained period of overvaluation is not necessarily a bubble—such periods usually end with corrections that bring prices down without flattening them. This creates a conundrum—how to spot a bubble before it’s too late?
In addition to stock prices surging to historically high levels that appear unsustainable, there are other indications that a bubble may be developing. Some are the human behaviors we describe in Curbing Our Enthusiasm to Avoid a Bursting Bubble's Fallout. Others are these economic and financial indicators most frequently mentioned by economic historians and seasoned market watchers:
- Unusually high use of credit to purchase assets. Buying stocks primarily on margin, making minimal down payments on homes and acquiring companies via highly leveraged buyouts are good examples.
- Higher-risk lending and borrowing. Just think of the U.S. housing bubble, when mortgages with onerous terms were aggressively sold to borrowers with limited ability to pay the mortgages back.
- Low interest rates. In and of themselves, low interest rates are a sound way to encourage investment, whether in securities, capital equipment, research and development or corporate acquisitions. But low rates also can be dangerous if they stimulate speculative activity, excessive indebtedness and greater overall tolerance of risk.
- Financial innovation. Big market participants are always looking for a financial edge. Two such innovations—futures-based portfolio insurance and credit default swaps—played major roles in the stock market crash of 1987 and the housing bubble, respectively.
- International trade imbalances. When nations save more than they invest, they eventually want to put those savings where they think they will earn a good return. Sometimes that increases the volatility of capital flows among countries—as happened in the housing bubble, when flows from savings-heavy Asian nations poured into U.S. properties and helped to keep prices rising.
- Heavy marketing or media coverage. If it seems like everyone is excited about a particular asset, chances are good that its upside either has peaked or is declining.
- Amateur hour. The market may indeed be veering off its tracks when all kinds of people with little knowledge of investing are talking like experts, with off-the-charts conviction about the inevitability of higher prices.
You’ve Spotted What Could Be a Bubble. Now What?
It is one thing to know about bubbles, understand them and even spot them, but quite another to manage a portfolio through them. There are a number of steps investors can take that are straightforward, time-tested and potentially savvy in any market environment.
The first is to work with one’s financial advisor to develop a long-term investment plan that can endure through good times and bad—and stick to it. In addition, investors should aim to:
- Avoid emotional attachment to holdings and try to keep feelings out of the decision-making process.
- Maintain a well-diversified portfolio, which is the best defense against almost any market volatility or downturn.
- Rebalance portfolios on a consistent schedule—annually, semiannually or quarterly are widely recommended—to trim exposure to bubbly assets and add to others that may show greater promise.
- Stay away from excessive leverage, whether in the form of buying stocks on margin or external borrowing to fund asset purchases. Leverage only worsens the potential losses from a bubble.
- Avoid investments that are hard to understand. Many investors—both individuals and institutions—racked up big losses in the housing and Internet bubbles because they bought complicated mortgage-related securities or stocks of companies with esoteric technologies.
If history teaches us anything, it is that bubbles will always recur. But by remembering that “This time, it is almost definitely not different,” investors can relearn this important lesson and focus on managing risk and protecting assets.
Related AMG Insights
For more on financial bubbles, see Crises, Manias and Irrational Exuberance — Financial Bubbles Throughout History: A Cautionary Tale.
For more on how emotions affect investing, seeThe Pitfalls of Emotional Investing and How to Avoid Them.
All investments are subject to risk including possible loss of principal.
Diversification does not guarantee a profit or protect against a loss in declining markets.
The foregoing discussion is general in nature, is intended for informational purposes only and is not intended to provide specific advice or recommendations for any individual or organization. Because the facts and circumstances surrounding each situation differ, you should consult your attorney, tax advisor or other professional advisor for advice on your particular situation.
Leveraged buyout—The acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.
Portfolio insurance—A hedging technique frequently used by institutional investors when market direction is uncertain or volatile.
Credit default swap—A swap is a derivative contract through which two parties exchange financial instruments (A derivative is a security with a price that is dependent upon or derived from one or more underlying assets.) A credit default swap is a particular type of swap designed to transfer the credit exposure of fixed income products between two or more parties.
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