Why it pays to take cries of “bubble” with a pinch of salt

“There is a bubble in the use of the word bubble”, quipped top-rated strategist Albert Edwards, nearly ten years ago.

The bubble that everyone was fretting about back then, during the post-2009 rebound – like so many supposed investment bubbles over the years – has not popped, but just continues expanding.

Today, the favourite target of bubble-watchers is the US market in general, and technology-related stocks in particular.

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But in common with a decade ago, just because a lot of voices are shouting “bubble”, that doesn’t make them right.

The difference between a “bubble” and a “mania”

It is two hundred years since the collapse of the South Sea Company and the simultaneous collapse of the Mississippi Company. The latter was the brainchild of Scottish financier John Law, and it all but bankrupted France.

The South Sea Company had a charter giving it a monopoly of trade with South America. But trade proved difficult, risky and unable to support the expectations of its investors. Instead, the company resorted to speculation, buying up the UK’s national debt in what was effectively an equity for debt swap. The share price multiplied nearly ten-fold before its collapse.

The word “bubble” was rarely used for the rest of the millennium, with the term “mania” being preferred. But there is an important difference.

“Bubble” implies that nothing will be left, either for investors or for the economy after it pops. “Mania” on the other hand, implies a speculative excess which results in over-investment. This decimates the return on capital of what had seemed a sure-fire growth proposition and so destroys the wealth of investors – but it leaves a lasting legacy.

For example, successive railway manias in the 19th century left a first-class transport network. Many economists argue that manias are an important contributor to successful economic development.

On a lesser level, markets or parts of them may simply be temporarily overvalued. A sharp fall may cause short-term pain for investors who fail to exit in time, but patience is rewarded when fundamental valuations catch up with the share price. Meanwhile, over-investment is averted and greater pain avoided.

To modern-day Jeremiahs, this is still a bubble. But in time these sorts of setbacks, such as the market crash of 1987 in which share prices fell by a third, become a barely visible blip on the long-term chart.

The “TMT” (technology, media and telecommunications) bubble at the end of the millennium contained elements of all three: bubble, mania and overvaluation. Some businesses which were once valued at billions, such as AOL, Freeserve and LastMinute.com, disappeared without trace.

Most of the telecoms companies also disappeared but left behind global networks of fibre-optic cable, without which the progress of the internet would have been much slower. Finally, the share prices of Apple, Amazon and Microsoft dropped sharply – but any investor who bought even before the fall and somehow held on would now be very happy.

Sometimes bubbles are justified, even if they’re early

Bubbles seem perfectly rational at the time and could not develop without the support of almost unanimous investment opinion. There are always a few nay-sayers whose objections, invariably too early, are dismissed at the time but later gloriously vindicated.

Indeed, so great are the accolades that follow, that many pundits strive for the exalted status of the seer who advised Julius Caesar “beware the Ides of March!” The result is a glut of perennial bubble-watchers targeting the wrong asset class at the wrong time.

And even those who seem to get it right can soon look foolish. In the late 1990s, legendary investor Bill Miller asked rhetorically: “is it right that the market value of Amazon is four times that of Barnes & Noble and Borders (America’s two largest booksellers) combined?”

He was right; it wasn’t rational; Amazon was much too cheap. Miller hadn’t grasped how Amazon would evolve into being much more than an on-line bookseller, just as early bears of Google, Facebook and Apple failed to see how those businesses could and would develop.

Manias can have negative economic consequences as well as positive ones. In the 1990s, merger mania created a mega-cap bubble from which the FTSE 100 has never recovered.

Despite ample evidence that mergers do not add value for the acquirers, investors bid up the share prices of acquisitive companies, encouraging ever more ambitious bids. The resulting corporate behemoths, such as HSBC, Vodafone and BP, have struggled ever since. That mania condemned UK investors to a slow lingering death, undermined the UK economy, and created banks that were “too big to fail”.

The ”peak oil” mania of the early 2000s by contrast, was a disaster for investors – but it resulted in cheaper, cleaner energy; less cash-flow to unstable regions of the world; and a probable peak in oil usage last year.

Back then, it was widely believed that demand for oil would go on rising, but supply would be constrained by a shortage of new discoveries. In 2008, the oil price reached nearly $150 a barrel while investment bank Goldman Sachs predicted that the next stop was $200.

But prices collapsed to $40 in the subsequent financial crisis and subsequent recoveries have not been sustained. The mania incentivised a surge in investment, much of it wasted, while the rest serving to increase supply. Meanwhile high prices encouraged more efficient usage, fracking and the development of alternative energy.

Ardent bubble watchers often miss the wood for the trees

Bubble-watchers last year were so fixated on supposedly expensive growth stocks that they missed the over-valuation of seemingly cheap, but poorly-performing income stocks, supported by unsustainable dividends. They are still convinced, as they have been for most of the last decade, that the technology-related sector is heading for a crunch, despite strong earnings growth regularly justifying high valuations.

The sector may still be over-valued after the recent setback and there has certainly been a mania, perhaps even accompanied by fraud, in some stocks. But this is a typical feature in growth areas of the market – and a very good reason for investing via a well-managed investment trust.

A more promising target for bubble-watchers is surely government bonds. But, again, the bears have been wrong for a long time. Investors may be guaranteed to get their money back, but yields of well below 1% provide scant return even with an annual inflation rate of zero.

A rate of 3% will, over ten years, reduce the real value (ie the value after inflation) at redemption by 26%; 5% inflation will reduce it by 40%.

In the 40 years between 1935 and 1975, holders of the undated 3.5% War Loan lost 80% of their capital; in real terms with income reinvested, the loss was well over 90%. The bonds were redeemed at par in 2014 but investors were ruined long before then.

History could repeat itself, but a slow puncture is more likely than the popping of a bubble.

Overvaluation, manias and bubbles are endemic to financial markets. But to all but a few, they are only obvious with the benefit of hindsight, and they are extremely hard to time; 1999 was a very painful year for bears of the TMT sectors, for example.

Investors think they have learned the lessons of the past but believe that “it’s different this time” – described by Sir John Templeton as the four most dangerous words in the English language. The relentless false warnings of the prophets of doom inure investors to risk – but they also understand that the price of trying to avoid all the hazards of the market is the sacrifice of the excellent long term returns on offer.

As Virgil wrote, “fortune favours the bold”.