Popping asset bubbles can wreak havoc in a portfolio – and in an economy. Here are the warning signs you should look for.
An asset bubble occurs “when the prices of securities or other assets rise so sharply and at such a sustained rate that they exceed valuations justified by fundamentals, making a sudden collapse likely,” according to the Financial Times.
Traders who correctly identify an asset bubble – or markets with “frothy” valuations – and subsequently time their trades in and out of this asset class correctly can protect portfolio downside and increase profitability.
What this means for traders
Property bubbles are the most well-known due to considerable media coverage, but any asset class – including equities, bonds, currencies and commodities - can become inflated in a fragile, upward price bubble, with valuations and investor appetite far exceeding their fundamental underpinnings.
Applying the asset bubble warning signs below, here are some examples of asset classes to watch:
Powered by loose monetary policies in the wake of the 2008 financial crisis, US equities have rocketed as quantitative easing (QE) has injected $3 trillion into the US economy.
As the economy improves and the US Federal Reserve seeks to unwind its QE programme, some market watchers worry the equity bubble might be about to burst.
If it does, many major stock markets are likely to experience a major correction, potentially as bumpy a ride as those experienced in 2010 and 2011, when previous programmes of QE were brought to an end.
“Extremely overvalued” is how below-investment-grade corporate debt has been described for nine consecutive months to July 2014, according to Bloomberg.
Some commentators mooted that the “dash for trash” may have ebbed in past months; while rock-bottom interest rates make riskier assets (including equities) more attractive, the potential for a junk bond ‘bubble’ remains.
While most day traders likely fret more about equities and property bubbles, central bankers consider the bond market a cornerstone to the economy; a bubble exploding here can rock the foundations.
In June 2014, the International Monetary Fund warned the UK government that accelerating house prices and low productivity pose the greatest threat to the UK's economic recovery. Photo: Shutterstock
Five ways to spot an asset bubble
1. Rapid price rise
Probably the most obvious bubble indicator, a rapid price rise also makes the asset more attractive to previously unconvinced investors who fear missing out.
2. Divergence between price and value
When asset price diverges sharply from its underlying value.
3. Increase in transaction volumes
The number of transactions in an asset will increase sharply during a bubble as buyers rush to claim their share of the windfall.
4. Easy access to capital
Investment capital becomes much easier to access when interest rates are low, leading to an asset buying spree which can inflate prices.
5. The latest fad
The development of a new technology or innovation creates excitement around an asset and drives prices higher. The stock market tech bubble in the 1990s is a perfect example.
In the past, bubbles have wreaked havoc on the markets, with a devastating impact on investors. To avoid getting caught in the next one, traders need to remain vigilant and watch out for warning signs when they start to appear.