How to distinguish a bubble from a bull market

Let’s start at the very beginning, a very good place to start.
When you read you begin with A,B,C
When you sing you begin with Do Re Mi
And if you’re thinking of investing in gold (at present) you begin with – Bubbles and Bull Markets

Well, like the Sopranos that hit high notes, both Bull markets and Bubbles are known for their upward climbs. And if you consider the number of previous bull markets that have ended up as bubbles, the mistaken-identity-crisis that these two phenomenons share is quite understandable - the primary reason why many investors misinterpret almost all long term rising markets (bull markets) as a recipe for asset bubbles.

How far can a bull market develop before it becomes a bubble? Well, there is no easy answer to that. In fact it is quite difficult to identify an asset bubble before it materializes, sometimes even after it has already formed.

Alan Greenspan, former Federal Reserve Chairman, was once quoted saying that, there was not much that central bankers could do about asset- price bubbles because it was too hard to spot them until after they had burst.

What really makes a Bull market? How different are Bull markets from Bubbles? Are they different at all?

Dictionary.com defines a Bull Market as

A financial market of a certain group of securities in which prices are rising or are expected to rise. Bull markets are characterized by optimism, investor confidence and expectations that strong results will continue.

A bull market is composed of an extended period of time during which the asset / instruments price continues to register “higher highs”. However, the price increases in a bull market are underpinned by strong fundamentals. As these well-grounded fundamentals get stronger by the day, prices continue moving upwards, in tandem with the fundamental story.

An interesting explanation on the Internet explains a Bubble as:

An extended period of extreme overvaluation. Bubbles can occur in almost all assets like stock markets, real estate, commodities and precious metals. There have even been bubbles in the flower market, the most famous example being the Dutch Tulip Mania of the seventeenth century.

A point worth noting here is that bubbles are formed when excessive speculation enters a market. Ever heard of the greater fool theory? - In a bubble market, speculators focus on the resale value of the asset rather than on its intrinsic value; irrationally high prices don`t seem to matter – what only matters is that the asset can be sold for an even more irrational price at a later date. Bubbles often end with steep declines, where most of the speculative gains are quickly wiped out.

The most important distinction between a bull market and a bubble is the deviation in an asset’s intrinsic value. Intrinsic value (here) refers to the price supported by an asset’s own fundamental factors i.e. prices ruling in tandem with its fair price. Simple, you say? Not really. Calculating the fair value of an asset is easier said than done. Hence, since the quantification of the fair value is difficult, it makes sense to refer to the strength of the fundamental factors that support the price increases.

The phases of a Bubble

Dr. Jean-Paul Rodrigue from Hofstra University, USA, has recently published a study on the different phases in a bubble. Though the situation for each bubble would obviously be different, there are a lot of similarities that come to light when analyzing bubbles over a period of 500 years; which is what Dr. Rodrigue has attempted through his research.

Using Dr.Rodrigue’s study, where would you place gold – Is it a true bull market or is it forming into a bubble? And, if it is advancing into a bubble, then at which stage are we currently in?

Before you jump to any conclusions, consider the fact that in the light of other monetary units getting devalued, gold remains the only currency whose supply is highly constrained. And thus, at current prices, gold at the extreme only looks fairly valued, and nowhere close to discounting the adverse effects of current policy making which continue to mount fiscal deficits and “incompatible-with-sound-money obligations” – social security, pensions, promised `free` medical care, deposit insurance, payments to bondholders, etc.

Chart: The Future is more worrisome

Sure, we recognize the possibility of a bull market transforming into a bubble. So, in the rarest of rare likelihoods that gold is pursuing the path of turning into a bubble, using Dr.Rodrigue’s chart, we could be staring at the “Awareness Stage”.

Earlier, we noticed some smart money enter the gold market, creating big positions and using much of the declines to increase allocations. Sounds a lot like the Stealth Stage, doesn’t it?

Currently trends observed reveal a lot of institutional participation coming in - central banks are adding gold to their reserves, while institutional participants like pension funds, wealth funds are considering allocations to gold.

The interest in gold doesn’t yet qualify for the mania stage, since public participation hasn’t been much to speak about, and nor has the media gone gung-ho about gold being the only asset one should invest in. And contrary to bubble behaviour, the increase in price has been a gradual and steady appreciation over a number of years. At the most, we just have seen some smart retail money allocate to gold considering its strong fundamentals.

If at all, this bull market is following course of being a bubble then we still are way off from reaching the new paradigm. Gold investors can continue to sing as strong fundamentals suggest that we are in a bull market which is currently nowhere close to being a bubble.

Disclaimer:

The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.