The biggest bubble in the financial world

There's a lot of talk about bubbles around at the moment. And I'm not surprised.

Margin debt (the amount of money borrowed to buy stocks) is at record levels. The S&P 500 looks expensive on long-term measures such as the cyclically-adjusted price/earnings ratio.

And when you're starting to see record prices again on various stock markets around the world India most recently it always brings out the jitters.

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But if you're looking for bubbles to fret about, there's another asset class out there that looks a lot more frothy than stocks

Why bubbles are poorly understood

For such an important market phenomenon, bubbles are very poorly understood. That's partly because the dominant view of markets the efficient market hypothesis still has difficulty even accepting the possibility of their existence.

Put simply, and without all the academic fudging, the 'efficient market hypothesis' argues that markets are priced perfectly. The 'wisdom of crowds' means that all available information is reflected in the share price. So the price is always right'.

If the price is always right, there can be no such thing as a bubble, because even apparently ridiculous valuations are always justified by the information available.

Clearly this is a world that would only make sense to an academic. It's obvious to anyone who cares to look that investors get carried away sometimes: the tech bubble and the US property bubble are just two recent examples in a long history of bubbles.

The tricky part is in pinpointing a bubble. For me, one of the warning signs is when people are investing in an asset class for all the wrong reasons. I'll explain what I mean.

A bubble normally starts with a good story'. For example, the internet is going to transform the world and save everyone a fortune and make life more convenient. So buy internet stocks.

That's a good story. So people buy the stocks. They go up and up.

And gradually the story changes to: people are making money by buying internet stocks. So keep on buying them.

Buy because it's going up' is not a great reason to buy any asset. But often it'll keep things going at this stage.

I'd say that the real warning sign comes at the resignation' stage. At this point, asset prices are at levels that are unprecedented. Anyone with a brain who's halfway honest can see that these things are expensive.

But there's a sense particularly among the professionals - of "what else are you going to do? This stuff's going up, so I have to keep buying."

So you get a lot of stories about how it's different this time', or people desperately looking for elaborate ways to invest in the story that don't look quite as dramatically overvalued. You often see lots of new funds launching at this point in the cycle, to take advantage of investor interest in the sector.

And I think this is the stage that fixed income' is at now.

Why the bond market is looking bubbly

In the fixed income' market, investors are doing things for all the wrong reasons. The assets they would normally invest in US government bonds, for example pay too little yield. In other words, they are very expensive.

Rather than sit on their hands because that's not what they're paid to do, even if it makes sense bond fund managers are instead sticking as much money as they can into other, riskier, higher-yielding assets.

So they are putting as much money as their own rules allow into bond-like equities. Or they are chasing junk bonds. Or they are setting up shadow banks' of their own.

Bank replacement finance' as big bond fund group M&G calls it looks like a huge opportunity. By lending money direct to businesses and funding commercial property deals, fund managers can get better yields and scoop up tasty fees in the process.

On the one hand, it's an innovation that I rather like. Our banking system could do with more competition. But shadow banking played a big role in the last financial crisis. Banks may have parcelled the dodgy mortgage loans up, but in many cases it was to satisfy demand from investors hunting for better yields than they could get elsewhere. So this looks more like last-ditch reaching for yield' than sensible opportunism.

So what can you do?

We've said this before, but one of the nice things about being a private investor is that you face none of the pressures that the City guys do. You don't have any glossy brochures dictating which sectors or assets you have to buy. It's entirely up to you.

One of the smartest things Warren Buffett ever said was his line about waiting for the fat pitch'. It's an allusion to baseball, which I have no interest in whatsoever. But translated into English, his point was that, as a free agent, you can just stand and wait until fantastic opportunities come your way. You don't have to buy anything if there's nothing worth buying.

And to be fair to Buffett, he's as good as his word. He spent ages before the financial crisis complaining that there was nothing really worth buying. Then, after 2008 nearly wiped out the banks, he saw that he could get Goldman Sachs over a barrel, and did a fantastically profitable deal with them.

Now, most of us aren't ever likely to be in a position to take the Great Vampire Squid to the cleaners. But the point stands. Don't buy stuff that's overvalued. Buy stuff that's cheap. For now, that would mean avoiding bonds.

As for stocks, we're not too keen on US markets. But other markets around the world including several European markets, and also Japan look reasonably priced. But we're starting to worry that one area pure income stocks are also becoming rather expensive. In the current issue of MoneyWeek magazine, my colleague Phil Oakley looks in more detail at alternatives to pure income stocks. If you're not already a subscriber, subscribe to MoneyWeek magazine.

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