Spotting Financial Bubbles Before They Burst
Seasoned expat investors have already experienced them first-hand. New expat investors know them from the stories. Both categories will recognize one when they see one. They think. They hope. Perhaps there is one among us now and we don't recognize them: financial bubbles.
Financial bubbles are of all times. The first documented bubble was the tulip mania in the Netherlands in the first half of the 17th century. The most recent was the US real estate bubble at the beginning of this century. The bursting of the tulip bubble did not do much damage. However, the US real estate bubble culminated in a global financial still visible today.
How do you recognize a bubble?
Once the price of an asset has risen sharply and seems too high, the media is quick to label it bubble. However, academics demand a clear definition, but the various schools cannot agree on the precise interpretation of the term bubble. In order not to fall into a semantic discussion - sometimes with far-reaching consequences, because on the basis of a definition some even deny the light of the sun - we prefer the somewhat vague description in which a bubble is nothing more or less than a sharp rise in the price of an asset followed by a sharp decline. How much the price rise and fall should amount to and over what period is - again - up for discussion, but an increase of at least 100% in a maximum of 3 years followed by a decrease of at least 50% in a maximum of 3 years seems to be a good rule of thumb.
Financial bubbles can therefore only be identified post factum. The analysis of bubbles will not lead to real-time recognition of bubbles. After all, in the rear-view mirror, causes and consequences seem to become more and more logical than they did at the time. Moreover, if bubbles were to be recognized at all, they would not cease to exist at all. The study of history does teach us that every bubble has a number of identical characteristics. Expat investors should be wary of these symptoms.
Is there a new bubble in the making?
The chance of a bubble seems now greater than ever. Financial markets are in any case like dry heath in a hot summer. All financial instruments are extremely easy to trade. High-tech financial technology makes even the most unwieldy assets liquid. Money and credit are plentiful as a result of years of loose monetary policy that resulted in extremely low interest rates. Speculation is human and all kinds of platforms and communities make it easier and cheaper than ever to start buying and selling.
The sparks are never far away. New technologies are emerging at a rapid pace and leave no sector untouched. Existing industries are disrupted, new ones emerge. An indicator of the bubble content of a new technology is the attention it receives, in the media, but also in company presentations. The emergence of a new buzz word is a clear symptom. Masking the inability to estimate the economic and financial impact of the new technology under a layer of rhetoric is one more. The role of government is often very subtle. A spark is given to achieve certain social or political objectives. Often the government even behaves like a pyromaniac. In addition, the government can also try to regulate oxygen, fuel and heat. Unconventional ways are not shunned.
Where could the bubbles be located today?
Of course, Bitcoin is one big bubble. One bitcoin is currently trading at around $62,000. Since its inception until October 2020, the price of one bitcoin has fluctuated between 3,500 and - on crazy days - 12,000 dollars. Bitcoin passes the 100%/3 year test with flying colours. The spark? Bitcoin is a new technology. Not a cat that has the slightest idea of what Bitcoin can mean in society, let alone what it could yield. The attitude of governments towards cryptocurrencies is not yet clear. Governments can brutally burst bubbles. It has already been proven that the crypto has what it takes to plummet.
The Nasdaq Composite Index, the indicator of the technology sector in the broad sense, flirts with 100% increase in 3 years. Abstracting from the brief COVID-19 slump in March last year, the SOX, the semiconductor index, rose almost continuously from 1,500 points in 2019 to about 3,500 points in September 2021. Within the FactSet World Index, there are a number of sectors that pass the selection test of at least 100% for a maximum of 3 years. This includes oil and gas drilling companies, electronic equipment manufacturers, financial publishers and service providers, semiconductor manufacturers, telecom equipment manufacturers, software developers, electrical product manufacturers and service providers to the medical sector and sea transporters. Everyone is now familiar with the phenomenon of false negatives in a rapid test. For example, alternative energy producers are only up 85% compared to 3 years ago, but this is after a correction of 20% since the beginning of the year.
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