In the aftermath of the technology boom/bust and the more recent commodity price collapse, investment ‘bubbles’ have become a big topic in financial markets.  Investors that want to protect the value of their capital need to be more wary of following ‘hot trends’ in investments and understand what causes these bubbles and how they can be recognized and avoided.  While it is difficult to ‘time’ the top in any over-valued asset class, reality always sets in and then the markets tend to ‘over correct’ to the downside.  In 2015, three major markets either collapsed or were incredibly volatile despite dire warnings – Energy, Chinese stocks and High-Yield Debt. 

When oil was trading comfortably above US$100, as recently as the summer of 2014, hardly anyone was talking about an imminent collapse, with many analysts calling for prices of $150 or even $200 in the longer term as global demand continued to grow and new supplies could not keep pace.  Eighteen months later we have prices down more than 60% and the consensus is for even lower prices in the near term.  With China, it has always been tough enough to get reliable economic information, so investors tended to be skeptical and few invested there directly.  But after Chinese stocks were added to some global indices in late 2014, new domestic investors went on a buying binge unlike any ever seen.  Average citizens added new accounts at unprecedented rates, encouraged by a government that needed to ‘recapitalize’ a depleted equity market and reduce the pressure on the enormous ‘shadow banking’ system.  The surge in prices was, of course, unsustainable and prices ultimately crashed in June, dropping over 40% in the following three months before stabilizing after massive capital injections from the government as well as restrictions on selling stocks by major financial institutions such as insurance companies.

Investors in the high-yield (junk) bond markets were scrambling to get higher income since they were ‘yield-starved’ because benchmark government interest rates were so low.  Investors basically chose to ignore caution and move into these higher risk assets.  Now, the high-yield market is under pressure and the pain is spreading from the existing investors to the companies who desperately need the cash that this market provided for them and they will have trouble raising funds elsewhere.

Investors have clearly become more wary of these investment ‘bubbles’ but they tend to believe that they are caused by excessive valuations only.  This is not necessarily true.  An old adage in the investment world says that ‘markets can remain irrational longer than investors can stay solvent.’  Certainly we saw that with the technology bubble in the late 1990s.  While Federal Reserve Chairman Alan Greenspan made his famous ‘irrational exuberance’ comment back in 1996, stocks continued to rise for another four years before finally succumbing to a bear market in technology that took over 15 years to recover.  ‘Bubble’ markets are not defined by excessive valuations as much as they are by a ‘misallocation of capital.’  This basically means that investors, who are not typically in those markets, are driven to be buyers but are not long-term investors and therefore become irrational and volatile holders of that asset class.  The current downturn in the commodity market is an example of how a bubble was created.  Rather than industry players (i.e. the producers and consumers of the physical commodities) being the main participants, financial investors joined the crowd as they saw that the growth in demand from emerging economies, combined with a decades-long under investment in new supplies, had given rise to a major bull market in many key commodities such as oil and gas, copper, gold and iron ore.  Over US$500 billion of new ‘commodity funds’ were started up between 2004 and 2008.  The markets for commodities had been small in the past and were unable to absorb all that new capital without driving prices higher.

The gold market was a classic example of what happened in commodities.  Gold started a bull market run in 2003 with prices below US$400 per ounce and peaked 8 years later at over US$1900 per ounce.  Much of the new growth in demand came from the ‘GLD,’ the NYSE-listed exchange traded fund (ETF) for gold, which was created in 2004 and grew to be the largest ETF in the world with a market capitalization of over US$40 billion.  But this trend has now reversed with assets in the GLD down over 50% since 2012, which has coincided with a price decline of over 40%.  The same phenomenon is exacerbating the problems of the overall commodity bear market.  A record $857 million was pulled this year from U.S. exchange-traded funds backed by broad baskets of everything from grains to metals.  The value of the funds plunged 26% as raw materials tumbled to a 16-year low.  The chart below shows the flow of funds into and out of commodity funds over the past 10 years.  While record inflows fed the bull market from 2006-2008, investors have turned tail in the past few years and 2015 saw a record outflow.

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