INVESTING IN A WORLD OF BUBBLES Northern Trust Investments is proud to sponsor this podcast Investing in a World of Bubbles. This podcast will be of particular interest to advisors looking to help temper investor enthusiasm when bubbles are building and ease fears when they inevitably burst. There is much talk these days of bubbles. Stock market bubbles. Bond bubbles. And, yes, real estate bubbles. While almost everyone seems to recognize bubbles in hindsight, few are able to identify them while they are occurring and fewer still can pinpoint when they will burst. For investors, bubbles can be particularly frustrating. How do you distinguish a bubble from a justifiable run-up in prices? At what point does an investment or market become speculative? And, once a bubble has burst, is it better to sell or ride it out? Unfortunately, there are no simple answers to these questions. Every bubble has its own unique circumstances and distinguishing characteristics. But by looking at bubbles historically and examining their commonalities the factors that create them, northerntrust.com
what makes them pop, and what happens once they burst investors can learn valuable lessons. The Anatomy Of A Bubble Webster s Dictionary defines a bubble as something lacking substance or solidity. In economics, a bubble is said to occur when asset prices increase significantly and continuously, fueled by investors expectation for further increase in other words, when prices deviate from economic fundamentals. Bubbles have common characteristics. There is a tendency for prices to rise in a parabolic fashion, starting gradually, then increasing rapidly as the general public fuels rampant speculation. Bubbles also involve widespread rationalizations as investors justify why it s different this time why valuations are actually reasonable and why the trend will continue far into the future (for example, the new paradigm of the late 1990s). Perhaps the most distinguishing factor of bubbles and what sets them apart from normal market run-ups is their disassociation from economic reality; prices are fueled by speculation and not gauged by historical metrics. Every Generation Has Its Bubble Bubbles have been a part of financial and market cycles for a long time. Within the past century alone, there have been dozens of bubbles the U.S. stock market bubble in the late 1920s, the late 1980s Japanese bubble economy, and of course, the dot-com 2
bubble of the late 1990s to name a few. And, what is now viewed as a bubble in the housing market is just beginning to play out. For many of us, the most vivid and painful bubble of recent memory is the dot-com bubble. This bubble saw tech stocks, as represented by the NASDAQ Composite index, double in value in 12 months, then collapse down to less then 40% of their value 13 months later. In hindsight, this was a classic bubbles, attendant with all the hype and rationalizations of overpriced assets. Yet the dot-com bubble is really no different from a number of other technology-inspired booms of the past, including railroads in the 1840s, automobiles and radio in the 1920s, transistor electronics in the 1950s, and home computers and biotechnology in the early 1980s. In fact, many view bubbles as a necessary corollary to the boom/bust cycle of capitalism. Some have gone on to suggest that their long-term impact has actually been quite positive. Because investment bubbles channel money to innovation, they allow new ideas and companies to get tested quickly. The successful innovations that come out of bubbles live on, and the infrastructure stays long after the bubble goes away. What s more, a periodic wringing out of the excess in certain market segments can be a healthy exercise and often sets the stage for future market advances. 3
Dot-Com Bubble Vs. Housing Bubble The dot-com bubble of the late 1990s represents a classic stock market bubble. It teaches us valuable lessons on both the up- and downside, and highlights some of the pitfalls to avoid in future bubbles. The housing bubble may not prove to be a bubble at all, but a temporary realignment of prices. Bubbles In The Making How do you recognize a bubble when it s happening? Although bubbles may be difficult to spot while they are in the making, there are certain characteristics that should serve as warning signs: Prices that rise steeply over a sustained period with no corresponding improvement in fundamentals. High-volume trading at prices that are at variance with intrinsic values The use of non-traditional value metrics such as estimated market share or market cap per use to justify prices. This time is different attitude and, finally, The Fear of missing the party investor mentality When The Bubble Bursts Financial bubbles, by definition, are destined to burst. It s just a question of when and how quickly. Stock market bubbles tend to deflate rapidly because stocks are highly liquid. It took just over two months for the S&P 500 to lose 45% of its value in 1929 4
and just six months to drop 25% in 2000-2001. Housing bubbles, on the other hand, take time to deflate; prices tend to rise or hold steady, even as buyers are disappearing from the market. For example, according to the U.S. Census Bureau, (based on sales and median prices of new single-family homes), in the housing slump that began in January 1989, prices did not peak until 16 months after sales began to slow, in April of 1990, and it took over two years for the market to hit bottom, in May 1992. In fact, the deflation of a bubble is much less consistent than its inflation. Bursting bubbles often have secondary effects that compound their collapse. A bursting stock market bubble, for instance, tends to cause a reduction in discretionary spending which, in turn, exacerbates or extends the downward movement in prices and can even precipitate an economic downturn. Such was the case in 1929 and, to a much lesser extent, in 2000. In both instances, stocks continued to decline for several years as the economy weakened and investors once again recognized the relevance of traditional investing concepts. Lessons For Investors While there is no way of avoiding bubbles altogether, there are certain practices investors can follow to help them recognize a bubble in the works and to help reduce its impact on their portfolios if they are caught on the downside. 5
Beware of the bubble hype When you come across terms like the new paradigm or modern valuation metrics that ignore traditional drivers of stock prices, such as earnings and cash flow then you are probably well into a bubble. Similarly, if historical valuation gauges such as P/E ratios are off the board, then bubble hype is likely driving prices. Question what is driving prices and whether it is sustainable. Look to the fundamentals Base your buying and selling decisions on fundamentals such as sales, earnings, and industry strength. Although past performance is no guarantee of future results, it can often serve as a guideline for determining whether future expectations are reasonable. Don t try to time the market Nobody can predict when a bubble will burst. Investors who heeded Alan Greenspan s now famous irrational exuberance warning in 1996 would have missed out on three years of the market s best performance. Instead, rely on the fundamentals to tell you when an investment is under- or overvalued. Once a bubble has burst, think twice before selling Just like on the upside of a bubble, markets tend to overreact on the downside, often sending prices below inherent values. Base any selling decision on traditional value metrics and a rational assessment of underlying fundamentals. Overreaction on the downside could also lead to buying opportunities for the diversified investor. Diversify One of the best ways of protecting against a bubble is diversification. While diversification does not ensure against loss, by diversifying your portfolio by asset class, investment style, geographical location, and industry, you stand the best chances of reducing a bubble s impact. 6
Consider two hypothetical investors at the start of 2000. The first invests $100,000 in tech stocks and the second invests the same amount in a diversified portfolio of stocks and bonds. As of June 30, 2007, the first investor would have a balance of approximately $66,000, while the second would have over $147,000. This represents returns from Standard and Poor s, Lehman Brothers, MSCI, and NASDAQ from January 1, 2000 through June 30, 2007. The diversified portfolio is 40% U.S. stocks (represented by the S&P 500), 40% bonds (represented by the Lehman Long-Term Government Bond Index), and 20% foreign stocks (represented by the MSCI EAFE index). Tech stocks are represented by the NASDAQ Composite Index, without reinvested dividends, which have historically been below 1%. Bubbles are clearly not going away. Financial markets are volatile by their very nature, and dreams of ever-expanding wealth are always seductive. The combination of the two has inflated more than a few bubbles over time and will do so again in the future. Recognizing a bubble for what it is and taking the necessary steps to reduce its impact will go a long way to making one more durable. Northern Trust Investments is part of Northern Trust, a global leader in the financial services industry serving investors around the globe for more than 118 years. We ve seen our share of bubbles and are ready to help you make the most of the opportunities ahead. We offer an expanding array of managed accounts and mutual funds to address 7
your asset allocation and diversification needs. To learn more, please call our Advisor Consulting Group at 877-867-1259 or speak with your Financial Advisor. More information is also available at northerntrustinvestments.com. {Disclosure} Northern Trust Investments, N.A. Past performance is no guarantee of future results. The information in this report has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. This report does not constitute investment, legal or tax advice. Any opinions expressed herein are subject to change at any time without notice. Any person relying upon this information shall be solely responsible for the full consequences of such reliance. Returns of an index do not reflect the deduction of any management fees, trading costs or other expenses. An investment cannot be made into a specific index. Indexes and trademarks are the property of their respective owners, all rights reserved. Diversification does not ensure against loss. 8