Investing In Shares

Why All Bubbles Pop Eventually

For most people the emotions of fear, greed and moving with the herd dictate their investment choices rather than dissecting the fundamentals of a company and its industry to find value.

One of the outcomes of emotional investing getting caught up in bubbles.

What’s a bubble?

“A bubbles is when the price far exceeds the asset’s fundamental value, to the point that no plausible future income scenario can justify the price” – Justin Fox.

When they look so obvious in hindsight, what motivates people to buy into a bubble?

Usually it involves a over estimating the potential returns (which usually centre on the future sale price of the asset rather than the cashflow it will produce), underestimating the risks involved, a basic investment thesis that seems believable and access to easy money (usually credit).

Even if you can spot a bubble how do you know when bubble is coming to an end?

“Speculative bubbles do not end like a short story, novel, or play. There is no final denouement that brings all the strands of a narrative into an impressive final conclusion. In the real world, we never know when the story is over” – Robert Shiller.

But eventually all bubbles pop (usually quite spectacularly when they are built on a foundation of credit) when buyers run out of money, price increases stall, the returns become marginal or the previously ignored risks become apparent (often all of the above).

Global property bubbles have been quite prevalent of late and Australia seems likely to be in its own. Yet in my opinion it’s most likely China’s bubble that will pop all the other bubbles, because its been China’s surging growth that has stimulated most other economies around the world.

In China’s case, it seems that property was a sound investment in the 80s and 90s based on the continued industrialization of China (income growth) supported by favourable demographics (demand growth) but a once a prudent investment has turned into a speculation as credit has grown substantially faster than income in the last decade.

chinese-credit-to-nominal-gdp

Now China’s house prices are amongst the highest in the world and private debt to GDP has entered the danger zone (above 200%):

 

china-private-debt-to-gdp-danger

Debts can only grow faster than GDP for so long before the increasing debt levels make the loan serviceability difficult.

Eventually either borrowers or lenders hesitate at taking/extending on more debt, resulting in sellers needing to drop their pricing to meet the market which now lacks buyers.

Once prices begin falling normally the assumption that “prices always go up” is debunk and the asset prices begin deflating.

That tipping point for China may be approaching.

In a recent report by GlobalPropertyGuide, it highlights that:

 

We found that rental yields on almost all sizes of apartments in Beijing were below 2.5%, and in Shanghai below 3.2%. It is hard to escape the fact that prices have been climbing steeply, while rents have not moved much.

Yields below 3% are a danger signal.

 

With rental yields this low buyers who use credit to procure their investment become very exposed to increases in interest rates.

And yet it seem that in recent weeks Chinese interest rates have been surging higher and are now at their highest levels in over a year:

china-10-year-yield

This increase in interest rates creates a large negative carry (ie costs more to hold the investment than it produces in revenue) from investing in property, which means you only make money if you are able to sell the property for a higher price…

 

Not only does a negative carry make the investment highly speculative, it also acts as a drag on the economy as increasing debt servicing costs reduces the disposable income of the asset owner.

 

These situations rarely lasts for long. Eventually concerned owners become sellers. Especially if they are retiring and no longer have an income from which to cover the negative carry on the investment.

 

The colossal amount of unsold apartment inventory and additional residential construction in the pipeline will not help the correction process:

 

china-housing-inventory

I suspect if the Chinese property bubble burst the flow on to Australian shares will be felt most in the mining sector as the demand for the resources to build ever more apartment evaporates as highlighted previously by this Tom Orlik:

iron-ore-imports

We truly live in a global world. And what happens in an economy as big as China will have an affect on the shares you invest in on the Australian stock market.