How to spot warning signs of a market bubble

Hollywood movies on natural disasters such as volcano eruptions and earthquakes always show how warning signs were usually ignored by sceptics, leading to catastropic disasters that take citizens unawares.

The same is true with markets. Investors ignore warning signs and then pay for their ignorance with heavy losses on price corrections. The bursting of the credit bubble in 2008 and the eurozone crisis in 2011, where markets corrected significantly had early warning signs that investors chose to ignore.

The unsustainable rise in property prices in the US on the back of lending to sub-prime borrowers and an unsustainable rise in the sovereign debt of eurozone nations led to market collapses, hurting investors. Investors should have listened to sane voices as markets went into bubble territory, but they did not and eventually lost money.

India, too, has had its fair share of bubbles and busts. Investors lost heavily in infrastructure and realty stocks when the market bubble burst in 2008.

The NSE Infrastructure index has lost 50 percent since February 2008, while the NSE realty index shed 80 percent in the same period. Warning signs were flashing for these sectors but were ignored by investors.

So, where are the warning signs? In hindsight, it is easy to spot these signs. But where do investors look today to find early warnings signs for trouble ahead? The warning signs are both macro and micro in nature. Macro signs affect markets as a whole, while micro signs will affect sectors or single stocks.

What are the macro warning signs?

Macro warning signs can emanate from within a country or from anywhere in the globe.

The macro warning sign in India right now is the Reserve Bank of India (RBI) supporting the government’s fiscal deficit by buying government bonds. The RBI has been buying government bonds for the past three years and taking up its balance sheet size by 270 percent.

The rising balance sheet size of the RBI has impacted inflation, which has trended at over 9 percent levels for most of 2011. The government too has not committed itself to reforms to bring down the fiscal deficit. Unless the government shows on-the-ground commitment to fiscal reforms, the Indian economy will flounder further.

On the global front, it is again central banks that are flashing warning signals. Central banks from the US Federal Reserve to the Bank of Japan have all expanded their balance sheets by buying bonds to provide liquidity.

The US Federal Reserve (Fed) has expanded its balance sheet by 277 percent in the 2008 to 2011 period.

The other central banks that have expanded their balance sheets during 2008-2011 are the European Central Bank (94 percent), Bank of Japan (49) and the Bank of England (166 percent). The total amount of central bank liquidity added between 2008 and 2011 is a staggering $4.5 trillion.

The repercussions of the huge liquidity infusion by central banks are positive in the short term but potentially catastrophic in the long term if liquidity is withdrawn from markets or if inflation trends higher.

What are the micro warning signs?

Micro warning signs emanate from regulatory action, excessive leverage and growth, poor corporate profitability, and corporates trying to cater to high market expectations.

Two recent examples of micro warning signs are Dhanalaxmi Bank and Mannapuram Finance. The two companies had high growth plans, but fell into trouble as they tried to achieve them.

Dhanalxmi Bank saw its financials deteriorate, while Mannapuram has been pulled up by the RBI for serious regulatory breaches. Everonn, an education company, is another example of fraud that was caused by an excessive emphasis on growth and market valuations.

Kingfisher Airlines, meanwhile, is a good example of poor profitability leading to corporate distress. The airline flashed warning signs much before it almost nearly bankrupt – it had stopped paying its dues to oil companies and banks, as well as its own staff.

Investors should watch out for such signs from other companies with poor profitability.

In the real estate sector, a build-up of excessive debt could cause some companies to sink. High leverage is usually built up in good times and investors should note the build-up of leverage when liquidity and interest rates turn negative for borrowers.

On the global front, news such as the world’s largest steel company, Arcelor Mittal, making losses due to poor business conditions in Europe is a warning sign for domestic steel makers.

Tata Steel, which acquired Corus in 2007 by taking on debt, will face issues, as Corus’ primary market is Europe. Weak economic conditions in Europe affect other steel makers, as prices will remain soft on global oversupply. Exporters of goods and services to Europe will also face issues if economic conditions remain weak there.

Investors must watch for these signs and monitor them closely. Some of these warning signs may remain warning signs, while some of them will turn into full-blown problems. The best way to react to the warning signs is to either reduce exposure or book profits continuously if markets keep rising.

Arjun Parthasarathy is the editor of www.investorsareidiots.com, a web site for investors.