Bubble rekindled
Posted on June 3, 2009 by Richard Beddard
Filed Under Investing |
In theory:
Don’t investors ever learn?
Where was the great revulsion? The feeling of utter despondency at the bottom of bear markets, when just about everybody capitulates and a consensus forms that things can only get worse.
For a week or two, back in March, the collective mood was very gloomy but then something happened. Markets around the world rallied strongly.
It’s a disappointment for value investors who may have thought they had a year or two to pick up really good companies at bargain prices, but behavioural investing guru and Soc Gen analyst, James Montier, thinks he knows what’s happening.
At the end of the dot.com crash in 2003 the US authorities by-passed revulsion by rapidly cutting interest rates and creating cheap credit, stoking speculative bubbles in the housing and stock markets. Now, they’re trying the same trick again, only the stimulus is greater.
Don’t investors ever learn?
Apparently they do. Using laboratory markets, where returns (dividends) are predetermined by researchers and subjects trade fake shares, experimental economists have shown that bubbles develop. They’ve also demonstrated that experience of a laboratory bubble doesn’t inoculate participants. Far from it, when people participate in the experiment for a second time, a second bubble of similar magnitude occurs, only this time it happens more quickly. Typically, participants explain that experience told them a bubble would occur, but they thought they’d be able to sell before the ensuing crash.
Only when you run the experiment on participants for a third time do they act more rationally, and the prices of the laboratory shares begin to reflect the returns on offer.
We can see this back in the real world, says Montier. It was the younger fund managers who piled into technology, media and telecommunications shares in the late 1990’s and 2000 according to this study (pdf).
Not having learnt the lesson between 2000 and 2003, once-bitten investors were suckered into the bull market of 2003 to 2007. But now we’re twice-bitten and share prices, at least in the US, have returned to ‘fair value’, will we shy-away from a third bubble?
Not necessarily, says Montier in a report he sent out today.
Vernon Smith, the ‘godfather of experimental economics’ and Nobel prize winner in 2002, set out with his collaborators to break the results of preceding experiments by producing a bubble among participants who’d already experienced two laboratory bubbles.
When they ran their experiment for the third time they halved the number of shares, and doubled the amount of cash each participant had. They also increased the variance of the dividend returns. The experimenters hoped this would stimulate speculation even among experienced participants, and so it did:
The bubble wasn’t quite as big as the bubbles produced by the same participants when they were less experienced but as you can see from the grey line, at one stage prices were almost double fair values (red line, which plots the expected dividend return over the remaining periods in the experiment).
Back in the real world again, Montier concludes that governments’ economic tactics to mitigate recession, slashing interest rates and printing money, could be the kind of shock that Smith and his collaborators created in the lab:
…I have no idea if the current policies of the Fed and other central banks constitute a large enough liquidity shock to reignite a bubble. But it certainly seems as if many market participants are now focusing upon the policy response as a key source of optimism. If this is indeed the case, then perhaps Smith’s latest work could sound a warning bell about the risk of yet another bubble (and, of course, yet another crash thereafter).
Human beings. Bonkers, aren’t they.
In practice:
UK still cheap
By my reckoning the UK market is still cheap. Its long-term PE ratio of 11 is only just over half its level two years ago. Even in March, when it fell to eight, it wasn’t as low as you might expect in a calamitous bear market, though. Long term charts of the US stockmarket show the S&P500 as low as 5 in the Great Depression, and now near its average of about fifteen.
A cheap market throws up many opportunities. Here’s a list of companies that meet my basic criteria:
- Cheap shares with price to average earnings ratios of less than 16, and…
- Financially strong companies, with F_Scores of six or more.
In theory, a broad selection of companies like this should make low risk, market-beating portfolios over three to five year periods, and I’ll be writing about many of these companies in the weeks and months ahead.
As usual the F_Scores are from Sharelockholmes.com and I calculated the Long-term PE ratios from earnings data exported from Sharescope.
-
Peter Hearn, OPD’s founder and biggest shareholder, is taking the company private just weeks after I decided the company was too risky. Investors may have made a quick buck as the shares rose from around 40p to the offer price of 57p, but the company’s admission that it might otherwise need to raise funds and dilute existing shareholders reveals the risks they were taking.
Comments
Leave a Reply
