Are we living in a bubble?

Another week, another record high for markets, supported by easing US interest rates and the AI investment boom.

Yet some high-profile voices are urging caution, comparing current markets with those at the height of the dot.com era. The Bank of England recently warned of a possible ‘sharp correction’ in financial markets if AI-related earnings expectations slowed. The head of the International Monetary Fund also commented that share valuations were near levels last seen at the turn of the century.

Other bubble-like similarities include the still unproven narrative that AI is a ‘once in a generation opportunity’, a 21st century version of the industrial revolution. How much of the investment undertaken will be recouped, even if AI shows itself to be a transformative technology?  

Yet the doubters are in the minority. Key technology companies investing in AI are highly profitable with strong balance sheets. They are funding this expenditure themselves, rather than relying on creditors. This reduces the chances of systemic risk. Crucially, valuations for many of these companies, while elevated, are lower than during the dot.com excesses.

Bubbles hurt!

A financial bubble forms when asset prices disconnect from fundamental values and jump to unsustainable levels. When bubbles go ‘pop’, markets experience an equally rapid correction. The effects can be both long-lasting and painful.

Bubbles have been a part of the investment landscape ever since financial markets started becoming regulated in the mid-1600s. During the Japanese asset price bubble in the early 1990s, Japan’s property market was worth four times that of the US. It took more than 34 years for the Nikkei 225 stock index to reclaim its 1989 peak.

More recently, the popping of the US housing bubble in 2007 led directly to the global financial crisis. Ironically, subsequent moves by central banks to slash interest rates pushed multiple asset prices way beyond their fundamental values, one of the key characteristics of a bubble.

Bubbles share many characteristics

Just as investors can name historical financial bubbles, they are probably able to identify some of their characteristics. For example, bubbles can start when a new idea’s early success fuels investor excitement. This can increase if early adopters are able to ‘cash in’, having made worthwhile returns on their initial investments. This helps fuel interest and draw new investors in, pushing prices even higher. If this momentum continues then valuations will often exceed conventional norms.

When bubbles burst, the correction can come rapidly. It can be set off by a failure to meet investor expectations, the emergence of a newer technology or a changing economic environment. Investors late to the party, institutional as well as retail, can end up with severe losses.

If investors know the warning sign of potential bubbles, why can’t they avoid them?

The opportunity to generate outsized profits in particular shares or asset classes is a tremendous pull factor for investors. A major factor is FOMO, the ‘fear of missing out’. This can occur when potential investors find out about others who have made returns many multiples the value of their original investment.

If prices continue to rise, some of those on the outside may want to join in before it’s too late. Their original instinct to buy based on fundamental valuation metrics would be worn away as the investment continues to climb. Emotions take over. Some of these investors may rationalise their actions by focusing on the possible ‘new thing’ which will be underpinned by a new way of working or living. ‘This time it’s different, isn’t it?’…

If enough investors adopt a similar stance, this will reinforce another characteristic: herd mentality. This is when investors taking the plunge gain confidence from others who are also doing the same. This can often result in passing off any decision making to others, in the belief that they are likely to know more about what is going on.  

A further influence is confirmation bias. This occurs when investors commit to a high flying investment, taking confidence from news or research which supports their position. Simultaneously, they will tune out any content which takes the opposing view. This narrative supports the view that in this case, rising prices are normal.

Overconfidence also plays its part. Latecomers often think they will be clever enough to get out before any trouble starts. Yet the speed at which a correction can occur, suggests that this is not possible. Investors can end up nursing significant losses.

Leaving a positive legacy

When bubbles finally go pop, they can leave behind beneficial effects. The railway infrastructure left behind after the 1840s Victorian railway bubble contributed to fewer but much financially stronger operators.

When the dot.com bubble burst, the technology heavy NASDAQ index lost almost 80% of its value. Amazon’s share price fell 90% but it adapted and recovered. Google, which was founded in 1998, did not become a public company until 2004, after the dotcom bubble had already popped. While bubbles are wealth destroying for many investors, some of what is left behind can have societal benefits.  

Companies able to avoid bubbles usually share some important characteristics. The first is a distinct, superior technology or competitive advantage. Google’s search engine and Amazon’s logistics expertise have helped these companies flourish. During the Global Financial Crisis, JP Morgan Chase managed to come out on top as it avoided many of the risky investments that plagued many other banks. It used its strong balance sheet to buy weakened rivals at knock-down prices.

Life beyond bubbles

Joe Wiggins, head of research at SJP commented that “it is very difficult to predict or time bubbles. Investors often lose a lot of money, not when a bubble pops, but from spending years trying to predict the next one. The result is they don’t benefit from the long-term beneficial compounding effects of holding shares”.

He observed that “although there are areas of the market where valuations look stretched relative to history (though not quite in bubble territory), there are also areas that seem more attractive. This includes smaller companies and shares outside the US. At SJP, the starting point for our Group Asset Allocation view is looking for signs of valuation extremes. Our preference is to allocate away from the most expensive assets, and towards those that are more attractively valued”.

This article is a general communication that is provided for informational purposes only. It should not be relied upon as financial advice, and it does not constitute a recommendation, an offer or solicitation. No responsibility can be accepted for any loss arising from action taken or refrained from based on this publication. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted.

Please note that past performance is not an indicative of future performance, and the value of an investment with St. James’s Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.