How to Spot a Market Bubble

by Saxo Capital Markets

According to the Financial Times 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.”

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:

• Equity market

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.

• ​High-yield junk bonds

“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.

Conclusion

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.

Disclaimer: This material should be considered as a marketing communication under the Financial Conduct Authority’s rules. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research, nor is it subject to any prohibition on dealing ahead of the dissemination of investment research. Saxo Capital Markets UK Limited (“SCML”) undertakes reasonable efforts to ensure that any information published in this communication is reliable. SCML makes no representation or warranty, or assumes no liability, for the accuracy or completeness of any information contained in in this communication.

SCML provides an execution only service and this communication does not take into account any particular recipient’s investment objectives, special investment goals, financial situation, and special needs and demands and nothing herein is intended as a recommendation for any recipient to invest or divest in a particular manner and SCML assumes no liability for any recipient sustaining a loss from trading in accordance with a perceived recommendation.

Saxo Capital Markets UK Limited is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871

– See more at: http://uk.saxomarkets.com/trading/markets/how-to-spot-a-market-bubble#sthash.NiHbVBWG.dpuf