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Studying the path travelled by asset price bubbles

Economists Kindleberger and Minsky described the life cycle of asset price bubbles. Investors repeat their behaviour.

In the case of asset price bubbles, this follows a pattern of five phases: (i) the birth of a boom; (ii) the nurturing of a bubble; (iii) euphoria; (iv) financial distress; and (iv) revulsion

• Looking at current metrics, we would appear to be in the stage of revulsion, a phase showing overwhelmingly cheap asset prices.

The rapid unwinding in equity prices since the middle of 2007 has brought us to levels of valuation that are normally associated with revulsion. P:Es are low and a dividend yield in the order of 5% is unprecedented in recent history.

• Cheap markets do not stay cheap. Historically, low price: book ratios are associated with handsome equity returns in South Africa.

The best five-year investment returns have been delivered by markets associated with revulsion. The current JSE price:book ratio of 1.5 times places the local equity market in very cheap territory.

Previous lows have been:

• 1.4 times in 2001. This was followed by a three-year return of 47% and a five-year return of 180%. 
• 1.2 times in August 1998. This low was followed by a gain in the JSE of 98% over the next three years and 106% over the next five years.

There is much that investors can learn from history.  To borrow from Mark Twain, one of the most important lessons is that whilst history may not repeat itself, it often rhymes. 

Following this line of argument, history and available evidence suggest that the time of greatest opportunity in equity markets is in the darkest hour when investors feel revulsion towards the asset class. 

Currently, this is the mood in many parts of the world, including South Africa. 

Yet, history teaches us that investors looking for exceptional opportunity should be giving close attention to equities.  Our research offers strong support for this sentiment.

• David McCullough, the American author, narrator and lecturer once remarked that "History is a guide to navigation in perilous times."

For investors, this observation is as important as legendary investor Sir John Templeton's statement that the four most dangerous words in investing are "this time is different". 

• Despite having access to the powerful lessons offered by history, investors tend to overlook this opportunity, preferring to be mesmerized by short-term market movements and enslaved to crowd psychology as they cling to the futile belief that, somehow, this time will be different.  
• In its most dramatic form, this repetitive behaviour plays out in the form of booms and busts or asset price bubbles and collapses.

For students of history, such as the prolific writer Charles Kindleberger and theoretician Hyman Minsky, there is much to learn from studying the path travelled by asset price bubbles.  

• Kindleberger and Minsky's message is simple: bubbles follow predictable patterns.  By recognizing these patterns, investors furnish themselves with the ability to avoid the frenzied inflation and collapse of asset price bubbles. 

In so doing, investors equip themselves to protect their investment capital from the devastating consequence of collapsing asset prices.

• Equally important, Kindleberger and Minsky's teachings demonstrate that it is in the final stage of the asset price life cycle, when most investors feel revulsion towards the asset class (such as technology stocks in the early 2000s), that the best investment opportunities present themselves. 

History demonstrates that it is in the darkest hour that the best investments are made - and not during moments of euphoria.  This critical observation runs contrary to the beliefs and actions of most investors.

• It is without coincidence that the global equity bubble that was pricked in the middle of 2007 repeats this pattern.  More importantly, the collapse in equity prices since then has left investors with a strong sense of revulsion towards equities. 

As Kindleberger and Minsky - as well as swathes of history - have shown, this loathing is misplaced. 

To take the point further, our observation of historical patterns and our analysis of equity markets, and the South African equity market specifically, tell us that it is in this period of revulsion that exceptional opportunity presents itself to investors. 

This time is not different.

Adrian Saville is CIO of Cannon Asset Managers and he holds a Visiting Professorship in Economics and Finance at the Gordon Institute of Business Science. Visit Adrian's blog at http://adriansaville.blogspot.com/