As market bubbles form, investors may want to take cover

Five years of rapid-fire money printing at the US Federal Reserve and easy money policies at other central banks have left trillions of dollars sloshing around the world financial system, and some of it is ending up in some rather odd places.

The froth can be seen in everything from Pakistan’s stock market to thoroughbred racehorses, rare paintings and gemstones, taxi licenses and the digital currency Bitcoin.

“When it gets like this, just pick your asset - a painting, a bottle of wine, whatever. It’s almost always a sign that there’s too much money floating around,” said Howard Simons, a strategist at Bianco Research in Chicago.

Certainly, the risks don’t look as great as they did in 2005-2007, when real estate prices in the US and other countries skyrocketed, then collapsed, triggering the financial crisis. The most inflated prices are in smaller pockets of the markets than they were back then, so there is less systemic risk.

More from Investing

MSMEs are breaking the traditional convention. Look who’s funding them Scale-up your startup without an investor! Here’s how

But if a series of smaller financial market bubbles deflate or even burst there will still be a lot of agony, investment strategists warn.

When the Fed does pull back from stimulating the economy by cutting back its quantitative easing program of bond buying - which is expected in the first half of 2014 - there could be some shocks for markets to withstand, said Win Thin, an emerging market strategist at Brown Brothers Harriman. “That could lead to some painful adjustments.”

One toxic corner of the markets can infect stronger assets as investors seek to raise cash to cope with a plunge. “What I learned in the last two bear markets is that it doesn’t matter if you own the crappy asset,” said Simons. “If someone else does and starts panic selling, it takes your good stuff down too.”

And a further bond market selloff, following the reversal this summer, could not only hurt investors but threaten a downturn - as mortgage rates and other borrowing costs climb.

ETERNAL BULLS

There is evidence of possible excess in many areas.

Getting into a taxi cab these days may no longer come with a menu of can’t-miss stock tips from the driver but the cab’s owner probably paid a steep price for the right to the license. At a New York auction last week, taxi medallions sold for more than $1 million, about double the prices paid five years ago.

As for U.S. stocks, it’s hard to find many bearish investors despite - or because of - the 26 percent gain in the S&P 500 index this year and the 166 percent rise since 2009.

In Europe, it often feels as if the continent-wide debt crisis that threatened the euro never happened. Price-to-earnings ratios have soared to 2007 levels even as earnings momentum has sputtered. Over the last month, short-selling has dropped to a seven-year low and top performers in the STOXX Europe 600 index .STOXX are shares that were once heavily shorted.

As hedge fund manager David Einhorn put it in a letter to investors in October: “When ‘high short interest’ becomes a viable stock-picking strategy and conventional valuation methods no longer apply for many stocks, we can’t help but feel a sense of dj vu,” he said in reference to the dotcom stocks bubble and bust in 1998-2001.

[caption id=“attachment_1228521” align=“alignleft” width=“380”]  So far, 199 U.S. companies have gone public this year, the highest number since 2007, and some of the first-day gains have been huge.AP[/caption]

IPO FEVER AT COMPANIES

That particular bubble turned investors, especially retail investors, into addicts for the latest stock offerings. And things are looking a bit frothy again. So far, 199 U.S. companies have gone public this year, the highest number since 2007, and some of the first-day gains have been huge.

Such a race to list is a sign that things are nearing a top, says Peter Atwater, president of Financial Insyghts, an investment advisory firm in Mendenhall, Pennsylvania.

While the broader U.S. market does not look particularly pricey - the S&P’s forward P/E ratio of 15 is about bang in line with the long-run average - individual stocks certainly do.

Look no further than some of the biggest names coming to market in recent years, such as the social media star Twitter or electric car maker Tesla Motors.

At current market prices, after almost doubling on its first day of trading, the micro-blogging site is valued at almost $24 billion despite being unprofitable. Tesla is trading at a P/E ratio of around 80 based on expected 2014 earnings.

Stephen Massocca, managing director at Wedbush Equity Management, said, “nobody in their right mind would make an all cash offer at current levels for a lot of these companies."

AND ON THE FOOTBALL FIELD

Even professional athletes are getting in on the action.

Arian Foster, a National Football League player with the Houston Texans, was the asset for a planned IPO based on 20 percent of his future earnings, which he had sold to San Francisco-based Fantex. The firm would then sell stocks based on Foster’s economic performance.

“I thought it was a joke,” said Daniel Morgan, senior portfolio manager at Synovus Trust Co. “They’re not robots, they wear down. What’s the life of an average guy in the NFL, four years?”

Fantex, though, had to postpone the Foster IPO after the running back suffered a season-ending injury, underlining just how risky an investment it would have been.

IT’S THE BOND MARKET, STUPID

By suppressing interest rates, central banks have yield-starved investors falling over themselves to lend money to companies with less-than-stellar credit records, as well as looking for some of those exotic investments.

Quite a few investors, frightened that super-low interest rates will start rising next year, have bought up floating-rate loans. The only problem: many have no covenants, which usually limit the amount of debt a borrower can take on and let lenders have a say in the business if things start to go sour.

“People don’t realize they’re taking a lot of credit risk,” said AllianceBernstein portfolio manager Gershon Distenfeld.

Meanwhile, high-yield bond issuers - companies with weak balance sheets and sub-investment grade ratings - are paying on average 5.8 percent to borrow, near record lows.

Default rates at around 2.5 percent are well below historical averages but Martin Fridson, head of FridsonVision, said recently he expects those default rates to spike to 8.4 percent between 2016-2020, which could cause a lot of forced selling.

POCKET MONEY

Perhaps one of the best ways to measure froth is to watch what the super-rich do with their pocket change. Lately, they seem to have developed an insatiable taste for fine art - a painting by Francis Bacon set a new high water mark when it fetched more than $142 million last week in New York. In Geneva, “Pink Star,” a flawless pink diamond the size of a plum, sold for a cool $83 million, a record for a gemstone.

Even the market for thoroughbred racehorses is roaring away. In Europe, a one-year-old horse that had never been raced sold this year for 5 million pounds, a record price.

“Most of the people involved in it are extremely rich, and lately they’ve had the money to spend,” said Alastair Donald, a horse-buying expert at UK racehorse agent SackvilleDonald.

“There are ways of making money with racehorses, but mostly, it’s a luxury, it’s fun. It’s about buying a dream.”

CURRENCY FOR CRIMINALS?

Association with drugs, money laundering and other illegal activities has not tarnished the virtual shine of Bitcoin, the digital currency not backed by any government or central bank.

The currency, whose supply has been carefully controlled, on Monday soared above $600 from below $80 in early July. Societe Generale strategist Sebastien Galy said Bitcoin is an example of “how far and aggressively greed can push a deeply inelastic market.”

And the casino approach isn’t restricted to developed markets by any means. Pakistan is nobody’s idea of a safe and predictable investment destination but one wouldn’t know it from the nation’s stock market. Pakistani stocks .KSE have nearly doubled since the start of 2012 and are well above their levels even before the financial crisis.

It’s another instance of the reach for yield driving political risk considerations out the window, says GFT Forex managing partner Boris Schlossberg. “The Fed’s QE,” he said, “is having a spillover effect all over the world.”

Consequences of the likely withdrawal of that support is the biggest issue for 2014. The risk is that even investors who have identified bubbles will wait too long to exit.

Reuters