Investment bubbles come along once or twice a decade is seems, and they should obviously to be avoided. One of the best ways to build a successful long-term investment plan is to simply avoid taking big losses (such as when an investment bubble bursts). Two recent investment bubbles the markets have experienced over the past 10 years were the technology stock bubble of 1997-2000 and the housing / real estate bubble over the past 5 years. Both of these bubbles have created horrible hangovers (and big losses) for investors who had too much money invested when they popped. It is very difficult (and often takes many years) to make up for big losses of 25% -50%. It is often tempting to invest in a bubble sector (or stay invested in a bubble sector) when the market is going straight up and you hear stories from your peers about how much easy money they are making. Unfortunately history shows that the risk / reward of doing so is not pretty.
Common signs of an investment bubble
o Everybody is in. People who are not normal stock market investors pour their money into the investment. It's so easy to make fast money in this bubble sector. You don't need any expertise or analysis; just buy whatever is going up the most. Cab drivers, schoolteachers, retirees and many other people who have never invested in stocks are piling in.
o A feeling that you can't lose. Great long-term secular "story".
o Dramatic increases in prices / values over 3-5 years.
o Valuation doesn't matter. Ridiculously expensive valuation relative to history. Creative new ways to value the assets (since using traditional metrics makes them look ridiculous).
o Buying simply because they are going up, not due to any rational analysis. Momentum investing. The buyers are mostly speculators rather than investors.
o Leverage or "creative" financing. Tech stock investors day-trading on margin. Homebuyers using 40-year adjustable-rate interest-only loans with low teasers.
o Artificial reasons pushing the market up.
o Excess liquidity fueling the increase.
o Great headlines. It's all people talk about. There are regular stories about the number of billionaires being created daily in the bubble sector.
o Massive and accelerating investor inflows of money into the sector over the past 3+ years.
The Chinese Stock Market Bubble
The market that currently most resembles a bubble investment sector as described above is the Chinese stock market. Warren Buffet commented on a recent trip to China that he does not find the Chinese stock market attractive after the big increase. Warren has recently been selling his PetroChina stake. The Chinese economy is hot right now growing at around 10% per year. China's future is a great long-term secular story. The Olympics are being held there in 2008. This is an obvious positive mega-trend in the world today. Bubble markets always have really great stories about why this trend is bigger and better and will be longer lasting than others. The world is different now with respect to the bubble of the moment. Don't you get it? But what do you pay for it?
The Chinese stock market is currently exhibiting all of the bubble market indicators as listed above, just as the prior technology stock and housing market bubbles did. The Chinese market is now trading at about 45+ times earnings compared to about 16 times for the US market. It was up over 100% in 2006 and has more than doubled again in 2007. The number of new investment accounts in China tripled in 2006. Beauty parlor workers are talking about what stocks to buy and are "doing their research". The Chinese have few other viable investment options now as fixed income investments yield less than inflation. An avalanche of money from around the world has been moving in and investing in Chinese stocks. The number of US mutual funds focused on China has expanded dramatically and their inflows are up massively. Could the Chinese stock market continue to climb dramatically from here (to even more overvalued levels)? Yes it certainly could. But as a rational long-term investor the risk / reward is not favorable right now in my opinion.
What usually causes the end of a market bubble?
o Excess supply / reduced demand. The high prices attract more capital which produces dramatically more supply of the bubble asset (more technology stock IPO's / stock issuance, more homebuilding, more Chinese IPO's / stock issues). The housing bubble caused housing prices to increase too much so that the average homebuyer could no longer afford (without creative financing) to buy the average house. This reduces demand.
o An economic shock or external shock such as a recession, terrorist attack, etc.
o Simply market fatigue as the excess optimism runs out of steam. Once the stock prices start to fall there is a reverse momentum stampede towards the exits which is just as dramatic as the run-up. At that point people start selling just because the price is going down, just as they bought simply because the price was going up.
o The Chinese stock market could run into trouble for a number of reasons such as rising inflation in China (food, energy), a stronger currency which along with inflation erodes some of their competitive advantage, economic growth which slows from the current very strong ( 10%) level, government actions to slow the economy / stock market / inflation, dramatic increases in the amount of stock being issued there, and changes in stock market rules which allow Chinese investors to invest a portion of their money outside of China (and into other markets like Hong Kong). Chinese stocks have rolled over somewhat in the past several months. I'm still bullish on China, but not bullish on Chinese stocks right now.