How to Profit From a Stock Market Bubble

Booms turn to bubbles when too many investors cotton on to a good story and buy in. A special report from John Stepek at our U.K. affiliate MoneyWeek Magazine says that investors can still profit from bubbles as long as they get their timing right.

Every bubble in history started with a good story. In the 1980s, it was the "Japan is better at everything" story. And in the 1990s it was the "new paradigm" story.

But as investors often find at great cost to themselves, a great story doesn't necessarily make a great investment. In 1999, we were all convinced that the Internet would revolutionize the way we did business; that within five years we'd all be buying everything online and fax machines and letters would soon be made redundant by email.

We were, as it turned out, right. However, as it also turned out, that didn't rationalize buying into firms such as or [neither of which ever made a penny before going bust] at the prices we did. Nor did it justify paying ridiculous sums even for a survivor such as Inc. (AMZN). The few years we thought it did represented the transformation of a good investment idea into a bubble. And when it ended, a lot of people lost a lot of money.

But the point investors should really take to heart is not the money lost in the carnage of the crash, but rather the money made before the crash. For example, if you'd bailed out of the market in 1996 - when Alan Greenspan first warned that tech stocks were overvalued  - you'd have missed out on four years of gains.

And even if you'd exited in, say, early 1999, you'd have missed Internet stocks jumping 61% in the fourth quarter of 1999 alone [the best gains of the entire tech boom]. The most money is always made at the very end of a bubble period.

So how do you know when a boom based on a good idea has turned into a bubble? And more importantly, how can you tell when that bubble is about to burst? This is the tricky bit. However, Robert Buckland and Orrin Sharp-Pierson of Citigroup Inc. (C) believe they may have found a few clues, if not the entire answer.

Basically, they suggest there are four stages to the credit/equity cycle. We're now at stage three. This is the stage where - although the credit markets are running into trouble, the equity markets still have a lot of room for gains. But with valuations increasingly stretched and volatility rising, these gains are more likely to be bubble than boom gains.

Investable Bubbles

So where will these bubbles be? Happily, the answer, according to Buckland and Sharp-Pierson, is in areas where most MoneyWeek and Money Morning readers are likely to be heavily invested already - sectors exposed to the "global growth" trade. These are "the stocks or markets that are perceived to be most positively exposed to a robust global economy, irrespective of the U.S. slowdown" - basically, emerging market or commodity plays. If we accept that the key to a good bubble is a decent story, this makes sense, as we've told the story on these pages dozens of time.

It goes like this: The emerging markets - China and India, in particular - are reaping the benefits of globalization and industrializing. This is creating increasingly affluent and urbanized populations who want to improve their lifestyles fast. As their economies grow, they suck up raw materials from around the world, driving up commodity prices, and the share prices of companies with exposure to these markets.

The Asia story has been a solid investment theme for several years now - commodity stocks have made strong gains, while emerging markets in general have performed well. But the idea has only really taken off in the wider investor imagination in recent months. The market has started to worry about the state of the U.S. economy and investors have begun to see emerging markets as a safe haven to escape America's credit-glut woes.

The result has been an extraordinary surge in a variety of stock markets. At one point recently, shares in Shanghai were up were 160% since the start of the year, while markets in Hong Kong, Vietnam, Pakistan and Indonesia were all up 40% or more. And that meant that a new "equity mania" focusing on these areas was possible, one in which people get carried away by the barrage of seemingly meaningful bits of business trivia [25% of the world's cranes are in China!] and use them to justify buying into expensive markets at any price.

While we're comfortable with the idea that over the long run - by that, we mean 10 years, 15 years or longer - assuming nothing horrible happens, India and China will be great superpowers and probably great investments, too. But just because they will almost certainly keep growing, it doesn't automatically make any sense for the Industrial and Commercial Bank of China to be the biggest bank in the world by market capitalization; or for insurer China Life Insurance Company Ltd. (LFC) to be more expensive than Warren Buffett's investment vehicle, Berkshire Hathaway Inc. (BRK.A, BRK.B).

The analysts at Citigroup point to a few more signs of stocks being in bubble territory. At the time they wrote their report, China "A" shares were trading at a Price/Earnings ratio of 50, not far off the peak levels Japanese stocks hit in the crazy days of the late 1980, when alarmist books and movies such as Michael Crichton's "Rising Sun," were meant to warn us how the Japanese Superman was poised to take over and dominate the world forever [which, itself, wasn't much before the heady bull market gave way to a 17-year bear market started....even so, the book remains a great read, and the flick is a favorite here at Money Morning].

And even our favorite emerging market, India, while not anywhere near the heady heights of China, was up 34% for the year at the time of the Citigroup study, meaning it wasn't exactly cheap, either.

"India remains right now the only Asian economy driven primarily by domestic demand and not by exports. This means it is fundamentally less vulnerable to a U.S. economic slowdown than other Asian countries," said Christopher Wood of CLSA, a provider of brokerage and investment-banking services in the Asia-Pacific market.

So many people agree with him that, according to Mark Matthews and Willie Chan of Merrill Lynch & Co., Inc. (MER), Indian stocks were trading at a forward P/E of more than 20 times, compared with a 10-year average of 16. And Bloomberg has it trading at 25 times earnings.

When and When You Can Cash In

So what's an investor to do? If you are going to buy into a new bubble, it might be best to do so via markets that have been lagging the big movers a little. We still like India, and there are several ETFs that give investors a good avenue. Barclay's iPath MSCI India Index ETF (INP) was up nearly 49% on the year, when this research report was written. And the India Fund Inc. (IFN) not only has a good performance record [up 46% in the past six months], but has a reputation for handing out fat dividends. 

Vietnam and the Philippines are also excellent emerging markets. Money Morning has extensively covered each country's growth record and identified profitable entry points for investors.

But if you are looking for something that hasn't really got going yet, what about Thailand?

Thailand's been showing signs of a looming spike in growth. It's the cheapest market in Asia, with a forward P/E of about 11, according to Merrill Lynch.

But without a Thai-targeting ETF or Thailand companies that are SEC-registered, American investors are limited to companies heavily invested in Thailand, or broader indices. One such is the FTSE/ASEAN Index Series, which covers Thailand, Indonesia, Malaysia, Singapore and the Philippines.

Just remember: Thailand is cheap for a reason - meaning we'll be speculating, rather than investing, at this point in that market.

It is also worth remembering that while all bubbles eventually end in tears, there isn't much point in fighting them while they're building. As Buckland and Sharp-Pierson discovered, "investors who try to fight the re-rating of these markets could suffer the same fate as those who tried to fight Japan in the 1980s, and TMT in the 1990s."

In short: Right call, wrong time.

Bubble or Not, Resources and Commodities Will Growth

There's another aspect to the emerging-market bubble story: The worldwide resources boom.

Even if the U.S. economy comes unstuck, and China no longer finds it as straightforward to export its goods, the country will still need raw materials to continue its infrastructure investment. China can't just grind to a halt, partly for fear of the resulting social unrest. That means the good times for commodity-related firms should continue for a long time to come. Now, of course, we don't want to get carried away by a good story, even when it comes to our favorite sector. So let's look at the valuations.

Until very recently, most of the big miners were trading at P/E ratios of 10 or less. That's starting to change, and in a big way. BHP Billiton Ltd. (BHP), a longtime MoneyWeek favorite, was recently up more than 70% from a year ago. Rio Tinto PLC (RTP) was up 43%.

The Financial Times reckoned the sector "has the look of a bubble," but we can't quite see where that look is. Sure, stock prices have gone up, but even now the forward P/E for the global metals-and-mining sector was recently still only 13, still below the 10-year average of 15 times, and well below this decade's highs of 20 times leading earnings. And wariness among mining firms has been partly responsible for holding back production growth - even though most metal prices "are far above the levels require to justify investment."

There's no bubble in the oil sector, either. BP PLC (BP) and Royal Dutch Shell PLC (RDS.A) are trading at P/E multiples of around 11, and are still being largely ignored by investors, despite the sharp rise in oil prices.

Given that oil prices look like they'll remain strong - and far above the levels analysts used to forecast earnings for the oil majors - we believe that blue-chip oil firms like these will soon start to benefit from the rush into the resources sector that miners have started to see.

Money Morning staff writers contributed to this report.

News and Related Story Links: