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How to spot the next bubble

New York - A string of exploding investment bubbles that started with the dot-coms and ended with mortgages and oil dominated the years from 2000 to 2009. And it looks like the next decade will be no different.

It doesn't seem to matter to many hedge fund traders and other professional investors that the Standard & Poor's 500 index has turned in its first losing performance over the course of a decade, having fallen 23% from 1 469.25 at the start of 2000 to its current 1 126.20.

Or that they or other investors helped create and then destroy the bubbles that left stocks worth $2.5 trillion less today than when the decade began - and that's before adding in the effects of inflation.

A mix of investor hubris, ignorance and piles of easy money created the bubbles. New ideas about where to invest seemed foolproof and greed crowded out doubts.

Many investors looking for the best returns failed to see the potential problems with an internet business that had no sales plan, or that thousands of expensive homes bought with no down payment might end up in foreclosure.

Now, these investors who fled the last blowups risk running smack into others. The Federal Reserve is keeping borrowing costs low to help revive the economy, and that means there's still plenty of easy money around, helping traders to inflate the price of everything from stocks to commodities such as gold.

"They've put out the biggest punch bowl in US history and people are guzzling from it," said Haag Sherman, chief investment officer at Salient Partners in Houston.

Human greed the eternal constant

It begs several questions: what will be the next bubble? Or is it already here? And, how do individual investors protect their savings?

Some analysts have already been asking if the stock market formed a bubble with its huge rebound this year. The S & P 500 is up 68.9% from the 12-year trading low of 666.79, its best performance since the 1930s.

Gold is also suspect. It's above $1 098 an ounce and up 24% in 2009. Other possible sources of bubbles include stocks in emerging markets such as China, where the Shanghai index is up 76.4% this year.

Analysts say it's in the DNA of markets to let ambition cloud good judgement and that even when investors learn or relearn a lesson about excess, many still forget it.

Moreover, investors still have $3.2 trillion in money market mutual funds that's waiting to be invested, according to iMoneyNet Inc. With so much cash available and investors hankering after big returns, analysts warn that bubbles may be inevitable.

The signs of effervescence can be hard to spot.

"Pets.com was going to have a market cap larger than Exxon Mobil," said David Darst, chief investment strategist for Morgan Stanley Smith Barney in New York, referring to the Website that collapsed in November 2000, nine months after raising $82.5 million from investors.

He said investors will keep getting tripped up as they find new ways to invest.

"Human nature doesn't change," Darst said. "Market mechanisms change but human fear, human greed will be like this decades and centuries hence."

The numbers from this decade tell a stunning story:

  • The Nasdaq composite index, powered by the dot-com buying that began in the late 1990s, went all the way up to 5 048.62 in March 2000, then crashed down to 1 114.11 at the depths of the 2002 bear market. It rose as high as 2 859.12 in October 2007, but no one expects it to return to its loftiest levels.

    And the indexes don't reflect inflation, taxes and fees, which take the value of an investment down further.

    Thornburg Investment Management, which analysed the value of investments beyond the decade, said $100 invested in 1978 would have been worth only $376 30 years later after accounting for inflation, expenses and taxes.

  • Crude oil, sparked by a weaker dollar and worries that oil producers would soon be unable to meet global demand, rose 71% in just six months to a high of $147.27 in July 2008. Prices then crashed down to $33.87 in just five months.

    The plunge was so precipitous that it destroyed several hedge funds that had bet oil would just keep soaring.

  • Low borrowing rates and insatiable demand for mortgage debt by investors made it easy to get loans. That helped prop up housing prices and fuel speculation on securities based on those risky mortgages.

    The peak came in April 2006; after that, home prices fell 31.9% to a low in May 2009, according to the S&P/Case-Shiller 20-city index. Along the way, two investment banks that bought mortgage-backed securities collapsed and the government spent hundreds of billions of dollars to prop up many commercial banks.

  • Prices for soybeans and corn hit record levels in the summer of 2008 as floods swept the Midwest and damaged key growing regions. In the first six months of the year, corn shot up more than 60% and soybeans rose more than 30%. The jump in prices was a boon to many traders, but led to food riots in Africa, Asia and the West Indies. By December of last year, both grains had lost half their value.

Analysts say the best way to avoid being caught by other bubbles is to remain vigilant about diversifying, the practice of investing in a variety of assets. It could also mean shedding some of the stronger performers to avoid some of the risks that the winners will falter.

"When something grows too big in the portfolio you have to force yourself to scale it back a little bit," Darst said. "There's no substitute for doing your homework, there's no substitute for asking questions."

By spreading their holdings around and saving more, investors can buffer against what many analysts worry will be the fallout from the low interest rates and easy money being used to help revive the economy.

Policymakers also have concerns. Fed chairperson Ben Bernanke said in November a policy favouring cheap borrowing risked setting more traps for investors. He said he didn't see any signs that a bubble is emerging, but also acknowledged that it is "extraordinarily difficult" to detect one forming.

Some analysts see bubbles right now.

Precious metal bubble?

Quincy Krosby, market strategist for Prudential Financial, is sceptical of gold's recent surge.

It's easy to see why gold could be in a bubble. Many investors who have bought gold are speculating that inflation will start rising because of all of the money coursing through the financial system. One of gold's greatest appeals is as a hedge against inflation.

"It will move up, but the music always stops," Krosby said of gold.

Simon Laing, a director at Newton Investment Management in London, noted investors are using money borrowed at low rates in the US and Europe to buy stocks in other markets - raising the prospect of new bubbles.

This comes as causes of past bubbles still present obstacles.

"I don't think we've taken the medicine yet," he said. "We've had a decade of bubbles and I still think we're in the same scenario."

Krosby said individuals shouldn't be fooled into thinking that regulators have been able to curtail risk-taking in the past two years since the collapse of the market for securities based on iffy mortgages.

"They're playing in a world where professional traders dominate even though we think we've gone through this tremendous regulatory revolution," she said.

- AP

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