How To Spot An Investment Bubble

Dubai’s rapid fall from grace has devastated many investors, but the smart investors had already taken their money out of Dubai a long time ago. These smart investors …

Dubai’s rapid fall from grace has devastated many investors, but the smart investors had already taken their money out of Dubai a long time ago. These smart investors were alert to the telltale signs of a market founded mainly on speculation. Dubai isn’t the only bubble, however, currently bubble potential exists in the Indian market, in stocks and most tellingly in gold, where growth has exceeded any basis in reality. There could still be money to be made in these markets, though, for daring investors who can access this window of opportunity before it slams shut, and exit before it shatters. For more on this, see the following article from Money Morning

The Dubai World default is a matter of only $60 billion – mere peanuts when compared to other elements of the global financial crisis. It’s thus of concern only to those silly enough to invest in real estate there (and the European banks foolish enough to finance it.) For the rest of us, it is a useful reminder that sudden collapses don’t really come out of nowhere – they can be foreseen, and smart investors can plan for them.

You see, I did foresee this one, for Money Morning readers – 16 months ago, before the global banking crash. Back in July 2008, I wrote that Dubai’s economy was “more bubble than boom,” that it had “a construction bubble worse than the Florida market and a monetary policy looser than Ben Bernanke’s” and that “its return to earth will be painful and probably not long delayed.”

Let me share with you the signals that flash “red” when a bubble is in progress – and that suggest a crash may well follow. Indeed, you can actually make money in a bubble – if you know what to look for.

Spotting a Bubble

The first sign of a bubble – and the most important thing to consider – is the existence of a major mismatch between the local interest rate and the local inflation rate. If the local long-term interest rate is substantially below the local inflation rate – other than in a really deep depression like one we experienced in the 1930s – then speculation is being subsidized by the financial system.

Take Dubai. Back in July 2008, inflation was 20% and rising. But you could get a home mortgage for 7% per annum. That’s a “real interest rate” of minus 13% per annum.

I don’t think there’s a single market that has had interest rates of negative 10% or lower and not had the market blow up. Britain in 1973 had that problem, and a deep real estate crash followed. Argentina had that problem in 2001 – and the economy collapsed. The German Weimar Republic had that problem in 1919. In that case, the hugely negative real interest rates persisted for four full years.

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At the end of that period, Germany ended up with 1 trillion percent inflation – hyperinflation.

A second sign of a bubble is when an economy doesn’t really have much of an underpinning – save for speculation.

The dot-com bubble of 1999 was like that: Even Amazon.com Inc. (Nasdaq: AMZN), and eBay Inc. (Nasdaq: EBAY) – solid and profitable companies now – were loss-making tiddlers back then. And, of course, there were hundreds of other 1999 “success stories” that are no longer with us.

Likewise, the subprime-mortgage market of 2005 – if one investigated – was fueled by “liar loans” and borrowers with no downpayment and very low “teaser” rates. Lots of people on Wall Street and among the mortgage brokers were making huge amounts of money, but they were selling mortgage products that were often worthless because the borrowers would never be able to repay their debts.

Dubai was like that. It had lots of the characteristics of other “bubble” resort areas – impossibly luxurious hotels, buildings intentionally designed to be the tallest in the world, and floating real estate islands.

At the same time, the Dubai economy had no obvious means of support: There is no oil there, meaning the nation relies on oil revenue from its other partners in the United Arab Emirates (UAE).

Reliable resources don’t have to be tangible, of course: Boston has no oil, but when you go there you can almost hear the throbbing from all the brains in its giant college community; and you can almost feel the money in the New England city’s giant fund-management business. But a big place, with no obvious reason other than real estate speculation for it to grow, will probably eventually crash.

The “Next” Dubai

A bubble can end in a number of ways:

  • It can end in an economic collapse and general default, as Dubai has done now or as Argentina did back in 2001.
  • It can end in massive hyperinflation, as with Latin America repeatedly in the 1950s through the 1980s and in the Weimar Republic of the 1920s.
  • Or it can end in a little bit of both, like Britain in the mid 1970s, where inflation rose to 25% and then gradually came down again. Britain didn’t even have a house price collapse – everybody’s incomes went up more or less with the inflation, and at the end of four years people could afford houses again so prices, which had declined only marginally, started rising once more.

You can make money in a bubble – indeed, it seems a pity not to, when prices zoom up so rapidly. You just have to be clever enough to get out before it bursts. With so much exceptionally cheap money sloshing around the world, there are other bubbles to watch and profit from.

Let’s consider a couple of examples.

India, for one, continues to grow very rapidly – it advanced at an 8.9% clip in the latest quarter. But India has a budget deficit of more than 10% of gross domestic product (GDP) and when money stops being cheap, it will have a tough time.

Commodities and gold are currently in a bubble. Gold – which set yet another record Tuesday – is the classic item for which nothing tangible supports the price. But while money is as cheap as it is, gold will continue its advance.

That means real estate is a lousy bubble investment, because you can’t be sure of selling it when you need to. Stocks and gold, on the other hand, are pretty good profit plays, provided the companies you’re investing in are not too small, so there’s ample liquidity.

But remember, what goes up must come down, and it may do so with a bump. So invest only a modest amount in the next bubble you spot. Otherwise you’ll lose precious capital during the day – and lots of sleep at night.

This article has been republished from Money Morning. You can also view this article at
Money Morning, an investment news and analysis site.

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