Trying to spot the next Financial asset bubble is a full-time job for investment analysts or pundits. There’s always something out there that looks overpriced.
However, bubble hunting is not an exact science. More often than not, the bubble calls are too early, or too late.
See also: Hidden Value Stocks by ValueWalk
So what how can you tell if you’re looking at an asset bubble? UBS’s Global Chief Economist Paul Donovan tries to answer this question in a research note published at the end of last week.
In the note, Donovan opines that there's no precise economic definition of what makes a financial asset price a bubble but in general, a bubble has four characteristics.
Searching For The Next Financial Asset Bubble
The first and most obvious characteristic of a bubble is that the asset price is "above its fundamental value." Although while this is the most obvious characteristic, it's also the hardest to define. Investors rarely agree on what the underlying fundamental value of an asset is (that's what makes a market after all). Some may have a more optimistic target than others. As Donovan notes, economists still "argue passionately about the fundamental value in Dutch tulip bulb prices during the early seventeenth century."
The second characteristic of a bubble is that the asset involved has to have "some kind of novelty." In all major bubbles of the past, the asset exciting investors has been new and comes with tremendous potential. Canals, railways, tuplis, internet stocks, and bitcoin, they've all been new products, with exciting prospects. Further, Donovan opines that a new financial innovation can also be the novelty. For example, large-scale joint stock companies in France and England in the early eighteen century were new and large-scale leveraged buyouts in the 1980s were new. All of these innovations and developments resulted in bubbles.
The novelty factor makes the intrinsic value of assets harder to compute, and therefore, fuels the bubble further.
This is where the third bubble criteria comes in: a bubble must promise real-world returns at some distant date.
All previous bubbles have, in on way or another, promised outsized gains in the future for investment today.
"The internet bubble promised that we would all be buying pet food online – not immediately, but in the new millennium. The gap between selling financial assets and achieving the real world returns lets irrationality build. The asset price continues to rise because "this time it is different" and bubble buyers believe that returns will come pouring in if only they wait long enough."
The final characteristic of a bubble according to Donovan is "that a bubble bursts." Unfortunately, for investors, this warning might come too late, although for analysts and economists (and value investors) the bursting provides some fascinating insight into the market and guidance on what future bubbles might look like.
Indeed, UBS gives no guide on the next financial asset bubble today, but one can use the checklist (probably not) to search for it!