Of bubbles and bonds

Investments have a fundamental value that can be calculated. For example, earned income sets a ceiling as to how much people can afford to pay for a home. Although there is a long-term correlation between earnings and home prices, in the short term, speculation can drive prices up dramatically.

In the long term, however, fundamental value is the only sustainable basis for pricing an asset – so what goes up too much must come down. The same holds true for all investments. ‘Bubble’ is a term used to describe this phenomenon whereby the price of a certain asset can rise to extreme levels before deflating or bursting.

WHEN THE BUBBLE BURSTS

One of the earliest documented examples in modern history occurred in Holland, where ‘Tulip Mania’ saw the price of a single tulip bulb reach the equivalent of more than 10 times the annual income of a skilled craftsman in 1637. In January 1720, shares in the South Sea Trading Company were issued at £128 per share. The price had risen to almost £1,000 by August and fell to around £100 by the year end, causing financial ruin for many. The general stock market mania in 1720 led to a share promotion in “a company for carrying out an undertaking of great advantage, but nobody to know what it is”. Someone once said that a long-term investment is a short-term investment that has gone wrong. However, as John Maynard Keynes once wrote, “in the long run, we are all dead”, so it is best to avoid buying when prices are inflated.

RECENT BUBBLES

In my previous article I mentioned the gold market bubble of the 1980s. The Japanese real estate and stock market bubbles peaked in 1989 when, famously, the Imperial Palace Grounds in Tokyo were worth more than California. Japanese asset prices have yet to recover from this period and stock prices are still down 75 percent from their 1980s peak.

HOW TO SPOT A BUBBLE

Investors can fear losing out on gains or fear losing the purchasing power of their capital, forcing prices to extreme levels. At other times, investors can expect to make fantastic returns very quickly when they hear that others have done so recently. When a pricing trend has been established for about three years, there is a tendency to believe that prices always move in that direction and that to invest in a rising trend is a safe bet. Even the most intelligent of individuals can get drawn in to this ‘madness of crowds’ behaviour. Isaac Newton sold his shares at a profit in 1720, saying he couldn’t “calculate the madness of men”. However, when he saw prices continue to soar, he was unable to resist the temptation and reinvested just in time to lose the equivalent of €3 million in today’s prices at the peak of the bubble.

‘I’M MORE INTERESTED IN THE RETURN OF MY MONEY THAN THE RETURN ON MY MONEY’

Thirty-year German government bonds recently offered less than 2 percent per annum compared to more than 7 percent before the debt crisis began. The problem with this ‘investment’ is that buying government bonds at very low yields doesn’t even guarantee the return of your money on paper, never mind after inflation. Governments can and do go bust, rendering their issued bonds worthless. They can avoid bankruptcy by printing money to magically make the real value of their debts (and hence bondholder capital and income) disappear. We are edging ever closer to the end game for the single currency in Europe, and while no one knows exactly how events will play out, history suggests many years of high inflation ahead combined with low interest rates. At current prices, ‘safe’ government bonds from the likes of Germany, Japan, the US and the UK may turn out to be as high-risk as those offered by southern European nations.

Philip Curran is an independent financial advisor based in Brussels