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How to spot a bubble (even when no-one is talking about it)

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There's something missing from the current market conversation. Despite some spectacular gains for stocks around the globe, no-one is using the b-word.

To professional traders, the habit of calling any rise in prices a bubble is as irritating as it is common. Commentators have attached the bubble tag to everything from Australian house prices to cryptocurrencies, yet the narrow rally in US tech stocks has somehow escaped the typification.

The lack of labelling is remarkable. After a decade of careless and loose use of the term, few seem willing to call out the current market. This is a reflection of the unusual times, and perhaps higher levels of investing inexperience.

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Volatility in markets can make investors nervous, but it is the traders' friend. Fast moving markets offer quick and large profits, so traders seek higher volatility, and a bursting market bubble is an ideal scenario for battle-hardened market veterans.

Traders look for bubbles. While there is no formal definition, there are three characteristics that indicate a bursting bubble.

The first is an increasingly steep run up in price. This is not just an uptrend. Steady gains over time, with an occasional pullback or correction, is a healthy way for a stock or a market to rise. Prices approach danger when there is an acceleration of the rise, to the point where they turn almost vertical. An exponential increase in price is the first sign of a potential bubble formation.

Technology company Tesla is exhibiting this characteristic right now. Its share price rose from just above $350 a share in March to trade at a fresh all-time high in June at $1027. While eye-catching, the gains were not especially steep. That changed in the first weeks of July. In just six trading days, the stock rose a further $400.  The vertical rise put Tesla on many traders' radar.

The second and third definitional characteristics of a bubble are a departure from any reasonable valuation methodology, accompanied by a version of an "it's different this time" argument. While markets evolve and change, human nature remains the same. It's never different.

At $1400 per share, Tesla is trading on a price to earnings multiple of 150 times. The Nasdaq P/E is closer to 43 times. Worse, Tesla's multiple is based on an assumption that profits will bounce back in the current quarter year after two quarters of losses.

Elon Musk is a remarkable man, and Tesla a fascinating company, but analysts' forecast of 35% long term growth do little to justify the current multiple.

Another way to put this is that Tesla's share price has outstripped any reasonable valuation method. Supporters of the company point to extraordinary innovation and disruptive products to argue "it's different". But ultimately an investment must offer a reasonable return. It's possible to form the view that the only way investors will receive a return on the current share price is the "bigger fool" theory - that someone will buy the shares purchased at today's prices at a bigger price tomorrow.

Predicting the future is a fraught business. Intelligence and hard work can increase the chances of making a good call, but all analysts end up with egg on their face at some stage. The building and bursting of bubbles are among the most chaotic of market scenarios, and getting them right is tough. However the rewards can be spectacular.

Traders turn to the share price itself for clues to timing the break of a bubble. They look for chart formations known as "blow-off tops". These take various forms, but the most common is to see a share price rocket higher, only to fall back to its starting point, in a single trading session. This type of price action may signal that control of the share price is passing from buyers to sellers.

In Tesla's case, this could be a $50 or $100 rise that is immediately sold back to the day's starting price. Tesla short sellers have worn horrible losses, and suffered the taunts of Tesla's founder. If and when a blow-off top forms, they may see rewards for their patience.

The information presented in this article is general in nature and should not be considered personal or financial advice. Seek independent advice and consider the relevant Terms and Conditions at cmcmarkets.com.au when deciding whether to invest in CMC Markets products. CMC Markets Asia Pacific Pty Ltd (ABN 11 100058 213 AFSL No. 238054)

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With more than 30 years' experience in the financial markets, Michael McCarthy is the chief market strategist for CMC Markets for Asia-Pacific. He provides local and global market analysis for the Asia-Pacific region, formulates trading strategies and plays a key role in educating clients. Michael has a Masters of Applied Finance from Macquarie University and specialises in derivative trading.
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