Every bubble in history has started with a good story. In the 1980s it was the ‘Japan is better at everything’ story, for example, and in the 1990s it was the ‘new paradigm’ story. But as investors often find out to their cost, a great story doesn’t necessarily make a great investment. In 1999 we were all convinced that the internet would revolutionise the way we did business; that within five years we’d all be buying everything – from our shoes to our groceries – online; and that fax machines and letters would soon be made redundant by email.
We were, as it turned out, right. However, as it also turned out, that didn’t mean that it made sense to buy into firms such as Boo.com, or Pets.com (neither of which ever made a penny before going bust) at the prices we did. Nor did it justify paying ridiculous sums even for a survivor such as Amazon.com. The few years when we thought it did represented the transformation of a good investment idea into a bubble. And when it ended a lot of people lost a lot of money. But the point investors should really take to heart is not the money lost in the carnage of the crash, but that if you’d bailed out of the market in 1996 – when Alan Greenspan first warned that tech stocks were overvalued (in his infamous “irrational exuberance” speech) – you’d have missed out on four years of gains. And even if you’d exited in, say, early 1999, you’d have missed the best gains of all: internet stocks jumped 61% in the fourth quarter of 1999 alone. The most money is always made at the very end of a bubble period.
So how do you know when a boom based on a good idea has turned into a bubble? And, more importantly, how can you tell when that bubble is about to burst? This is the tricky bit. However, Robert Buckland and Orrin Sharp-Pierson of Citi believe they may have, if not the answer, at least a few clues. You can read a more detailed account of the model (produced by Citi’s credit strategist Matt King) below, but basically, they suggest there are four stages to the credit/equity cycle. We’re now at stage three. This is where, although credit markets are running into trouble, equity markets still have a lot of room for gains. But with valuations increasingly stretched and volatility rising, say the analysts, these gains are more likely to be bubble than boom gains.
For the nervous, that might suggest now is a good time to sell up and find a decent bank account for your cash (click here for ideas on this). But for the more speculatively inclined, it might instead look like a fine chance to make a fortune. So where will these bubbles be? Happily, the answer, according to Buckland and Sharp-Pierson, is in areas where most MoneyWeek readers are likely to be heavily invested already: sectors exposed to the “global growth” trade. These are “the stocks or markets which are perceived to be most positively exposed to a robust global economy, irrespective of the US slowdown” – basically, emerging market or commodity plays. If we accept that the key to a good bubble is a decent story, this makes sense. We’ve told the story on these pages dozens of time.
It goes like this: emerging markets, and China and India in particular, are reaping the benefits of globalisation and industrialising. This is creating increasingly affluent and urbanised populations, who want to improve their lifestyles fast. As their economies grow, they suck up raw materials from around the world, driving up commodity prices, and the share prices of companies with exposure to these markets. From this follows the idea that China, India and other emerging markets can keep growing even as the US and UK collapse under the weight of years of overconsumption and debt. We aren’t entirely convinced on the last bit of this (see our cover story in issue 352, Can Asia really drive global growth? for more on why we think the decoupling theory is more a function of wishful thinking than reality). But for a bubble to develop, all that matters is that other people are convinced. And so far, it seems that they are.
The Asia story has been a solid investment theme for several years now – commodity stocks have made strong gains, while emerging markets in general have performed well. But the idea has only really taken off in the wider investor imagination in recent months. The market has started to worry about the state of the US economy and investors have begun to see emerging markets as a ‘safe haven’ to escape America’s credit-glut woes. The result has been an extraordinary surge in a variety of stockmarkets. Shares in Shanghai have risen 160% so far this year, while markets in Hong Kong, Vietnam, Pakistan and Indonesia are all up 40% plus. Emerging markets are being seen as “the new growth engine that cannot be derailed”, says Morgan Stanley analyst Teun Draissma, who first advised investors to sell out of the market just before the correction in June, then called the bottom of the correction almost to the day in mid-August, in the FT. And that means that a new “equity mania” focusing on these areas is possible, one in which people get carried away by the barrage of amazing emerging market statistics (25% of the world’s cranes are in China!) and use them to justify buying into expensive markets at any price.
At MoneyWeek, we wonder if that mania might not have already started. We’re comfortable with the idea that over the long term – say, 15 years – assuming nothing horrible happens, India and China will turn out to be great super-powers and probably great investments too. But just because they will almost certainly keep growing, it doesn’t automatically follow that it makes any sense for a Chinese bank – the Industrial and Commercial Bank of China – to be the biggest bank in the world by market capitalisation; or for insurer China Life to be more expensive than Warren Buffett’s investment vehicle, Berkshire Hathaway.
The analysts at Citi point to a few more signs of stocks being in bubble territory. A graph of the Chinese stockmarket in particular is starting to look uncannily like a chart of the global tech sector in 2000 (see graph). China A shares are on a trailing p/e of around 50, not far off the levels Japanese stocks hit in the crazy days of the late 1980s (just before the 17-year bear market started). And even our favourite emerging market, India, while not anywhere near the heady heights of China, is up 34% so far this year and isn’t exactly cheap. Christopher Wood of CLSA points out that “India remains right now the only Asian economy driven primarily by domestic demand and not by exports. This means it is fundamentally less vulnerable to a US economic slowdown than other Asian countries.” But so many people agree with him that, according to Mark Matthews and Willie Chan of Merrill Lynch, Indian stocks now trade on a forward p/e of more than 20 times compared with a ten-year average of 16. Bloomberg has it on 25 times.
So what’s an investor to do? If you are going to buy into a new bubble, it might be best to do so via markets that have been lagging the big movers a little. We still like India – buy it via the Lyxor ETF India (LNFT), which tracks the performance of 50 of India’s biggest companies. But if you are looking for something that hasn’t really got going yet, what about Thailand? It’s the cheapest market in Asia, on a forward p/e of around 10.9 (according to Merrill Lynch).
You may think there’s good reason for this – the political situation is uncertain and there’s still lots of scope for more investor-unfriendly developments. Yet one thing to remember about bubble conditions is that overexcited investors are indiscriminate traders. Just as anything with ‘.com’ in the company name went up 50% a week in the twilight hours of the tech bubble, so all emerging markets are likely to be lifted if a real bubble kicks off in Asia.
So as the currently least-appreciated emerging market, Thailand might suddenly find itself popular with those who feel they’ve already missed out on the big gains in China and elsewhere. You can buy in via the Aberdeen New Thai Investment Trust (ANW). Just remember: Thailand is cheap for a reason – we are more speculating than investing here. It is also worth remembering that while all bubbles eventually end in tears, there isn’t much point in fighting them while they’re building. As Buckland and Sharp-Pierson put it: “investors who try to fight the re-rating of these markets could suffer the same fate as those who tried to fight Japan in the 1980s, and TMT in the 1990s.” Right call, wrong time.
There’s another aspect to the emerging-market bubble story: the resource boom, which is linked to the emerging market and the global growth stories. The idea that there might be a bubble building here has been knocking around for ages. It’s also been nonsense for ages. There have been excellent reasons for commodity prices and related equities to rise, and there still are. Even if the US economy comes unstuck, and China no longer finds it as straightforward to export its goods, the country will still need raw materials to continue its infrastructure investment. China can’t just grind to a halt, partly for fear of the resulting social unrest. That means the good times for commodity-related firms should continue for a long time to come. Now, of course, we don’t want to get carried away by a good story, even when it comes to our favourite sector. So let’s look at the valuations.
Until very recently, most of the big miners were trading on p/es of ten or less. That’s starting to change. BHP Billiton (BLT), a long-time MoneyWeek favourite, is up more than 70% on a year ago, while other mining majors have also risen strongly, such as Xstrata (XTA) (up 47%) and Rio Tinto (RIO) (up 43%). Lex in the FT now reckons the sector “has the look of a bubble”, but we can’t quite see where that look is. Sure, stock prices have gone up, but even now the forward p/e for the global metals and mining sector is still just 13, still below the ten-year average of 15 times, and well below this decade’s highs of 20 times. And wariness among mining firms, which remember the long commodities bear market of the 1980s and 1990s, has been partly responsible for holding back production growth – even though most metal prices “are far above the levels require to justify investment”.
There’s no bubble in the oil sector either. BP (BP) and Shell (RDSB) are trading on p/e multiples of around 11, and are still being largely ignored by investors, despite the sharp rise in oil prices. Given that oil prices look set to remain strong – and far above levels that analysts use to forecast earnings for the oil majors – we find it hard to believe that blue-chip oil firms like these won’t soon start to benefit from the rush into the resources sector that miners have started to see. It might end in a bubble (in which case, we’ll try and get out before the end), but it isn’t one yet.
The biggest correction is just around the corner
Citi analysts Robert Buckland and Orrin Sharp-Pearson reckon we’re in the “mature bull” phase of the credit/equity cycle. This cycle, they say, has four phases, shown in the chart below.
Phase 1, the mature bear stage, is basically the recovery phase that follows a bust. Companies are starting to repair their balance sheets and buy back debt, so credit spreads (the gap between the yield on corporate debt and risk-free government debt) narrow, and it’s a good time to buy corporate bonds (because debt is being repaid, so bond prices rise, while yields fall). At this stage, equities are still falling because investors continue to lack confidence, and also the balance sheets are often being repaired with money raised through share issues.
In phase 2, the credit repair stage is over, profitability starts to pick up, as does corporate cash flow. At this point, credit spreads narrow even further, while share prices start to rise. This is the immature bull phase, say Buckland and Sharp-Pearson. They believe we entered phase 2 of the current cycle in March 2003, when the equity market bottomed out.
Then in phase 3, the credit bull ends – as has just happened with the summer credit crunch. Investors become wary of leverage and spreads start to widen, but equities still rise amid easier monetary policy (as central banks try to stave off the credit problems) and as money flows in from investors switching out of other, less attractive asset classes (investors selling out of buy-to-let and transferring into stocks, for example). This is the mature bull and this is when bubbles in the stockmarket start to erupt, usually building on “a theme that has been strong in Phase 2” – which, in this case, is the global growth story. Prices are driven to “spectacular and ultimately unsustainable levels” before the bubble bursts.
This leads to phase 4, the “classic bear market”, or immature bear. This is when both credit and equities fall. Balance sheets deteriorate, profits fall, the market is awash with profit warnings and bankruptcies. Unsurprisingly, “a defensive strategy is most appropriate” here, with cash and government bonds the best performing assets in this type of market.
So what can investors expect from markets now? The authors point out that although the average gains in the immature and mature bull phases are similar, “the quality of those returns is worse” in the mature bull. Stocks are more volatile and the mature bull phase is shorter. In other words, people know there’s trouble brewing and become more jittery.
This volatility means that using borrowing to try to improve returns in this phase isn’t a good idea either. As Buckland and Sharp-Pearson note, in 1998, near the start of what they believe was the mature bull phase that gave rise to the tech bubble, global equity markets fell by more than 20%. It was a buying opportunity in that instance, but anyone using debt – such as infamous hedge fund Long Term Capital Management – would have been wiped out.
So investors need to be willing to put up with more of a roller-coaster ride than before. Economist and stockbroker for Pali International, James Ferguson, has recently noted in his Model Investor newsletter that even on those occasions when stockmarkets have managed to thrive during a US recession, they have tended to suffer three separate corrections of increasing size.
These take place just before the recession hits, as investors come to terms with impending economic slowdown. By James’s reckoning, we’ve already seen the first two – in May and again in August. The next, and largest, averaging about 18% – 22%, should be right around the corner. So last week’s blip, which the press somewhat lazily termed ‘Black Monday revisited’, could be the start of something bigger.