The next big investment bubble - green energy

Do investors have any bubbles left in them?

In the days of free and easy money, under the leadership of Federal Reserve chief Alan Greenspan (once dubbed the 'Maestro', though strangely enough, not any more), investment became a big game of 'spot the next bubble'.

With hindsight, investing was easy. You just had to ignore things like fundamentals and rationality, and buy whatever everyone else was buying. Trouble was, you also had to avoid being the 'greatest fool', and bail out before the bubble popped. Lots of people didn't, hence the current pain being caused by the property slump.

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Losing money in bubbles is painful and teaches a hard lesson. We've had two in less than a decade the tech bubble and then the property bubble. Surely it would be difficult to take investors for a ride again?

Certainly it would be difficult. But not impossible.

Investors do learn from bubbles...

James Montier at Societe Generale is a specialist in 'behavioural finance'. This basically takes psychology and applies it to the field of investment and economics.

As someone who's studied psychology in the past, I'd be the first to admit that it's a pretty 'soft' science compared to something like physics, for example. But compared to the pseudo-science thatis economics, it's positively respectable.

And given that markets are anything but rational (even the Chartered Financial Analyst Society of the UK admits that a majority of its members have lost faith in the 'efficient markets hypothesis'), it makes a lot of sense to take investors' all-too-human characteristics into account when trying to figure out what markets might do next.

In a recent research note, Montier took a look at the psychology of bubbles. As suggested earlier, you'd think that investors would learn. If they'd seen one bubble, they'd be more careful in future.

And in fact, they do learn. An experiment conducted by joint Nobel prize winner Vernon Smith used an investment game where investors could trade a dividend-paying equity under four different random economic conditions, each of which would result in a different dividend payout.

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In the first game, investors at first undervalue the equity, then massively overvalue it, creating a bubble which then deflates. Smith then got the same people back to play the game again. What happened? Well, says Montier, "far from learning from their experience in the first round, participants generally go on to create yet another bubble!" And when they were asked why, "the most common response was they thought they could get out before the top this time!"

However, when Smith asked the same players to play a third time, this time they'd learned. "You end up with a much tighter correlation between the market price and fundamental value," says Montier.

So twice bitten, thrice shy, it seems. And you might therefore expect the current generation of investors to have learned from the two big bubbles of the past decade.

...but they can get sucked into creating them

But that's not the end of the story. Smith found that there was a way to get experienced investors back into bubble mentality. How? He cut the amount of stock available in half, and doubled the amount of cash in the game, "effectively creating what might be termed a massive liquidity surge." This time around, even the experienced investors were sucked back into creating another bubble, although it peaked earlier than the previous ones.

"A massive liquidity surge" is exactly what the world's central banks are trying to create just now. Montier says he has no idea if it will be large enough to "reignite a bubble (and of course another crash afterwards)." But as US fund manager Jeremy Grantham of GMO has pointed out previously, we're currently seeing "the greatest monetary and fiscal stimulus by far in US history". So if that doesn't do it, arguably nothing will.

The next big investment bubble

We're not sure that investors have another bubble in them just yet. But with all that money floating around, it's eventually going to go somewhere. And one area stands out as a prime candidate alternative and renewable energy.

The sector has the heavy backing of the government. It has some great stories behind it solar towers, wave farms and electric cars all linked together by smart grids, already being hyped as "the energy internet" (you can read more about smart grids in our recent cover story How to plug into America's $4.5bn energy upgrade- although be aware that the stocks tipped in the story have gone up substantially in the past few months since it was written and we've taken profits on most of them).

There's also a genuine infrastructure problem to solve. The laying of internet cables and railway lines bankrupted many people and companies. But those bubbles created the infrastructure necessary to improve our lives and increase productivity and efficiency. Alternative energy has a similar driving force behind it. Regardless of your take on the greenhouse effect, you can't deny that it would be useful to reduce our dependence on oil.

So the conditions are ripe in the alternative energy sector for a bubble. We'll be keeping an eye on the sector in the coming months. But my colleague Merryn Somerset Webb tipped a good fund to get wide exposure to the sector last week you can read about it here: Buy into the green boom. (If you're not already a MoneyWeek subscriber, subscribe to MoneyWeek magazine.)

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