Beating bubbles

Asset bubbles can be avoided, and strategic asset allocation will only maintain exposure to underperforming assets, according to farrelly’s principal Tim Farrelly.

Speaking at the Self-Managed Super Fund Professionals’ Association of Australia (SPAA) annual conference in Brisbane yesterday, Farrelly demonstrated how a simple formula could be used to identify asset bubbles. He illustrated his point using bubbles from the past, including the gold bubble in the 80s that saw gold fall 71 per cent from peak to trough; Japanese residential property, which fell 65 per cent in the early 90s; and US real estate investment trusts (REITs), which fell 71 per cent in 2007.

“If you buy them at too high a price it is an absolute disaster that will be with you and your clients for a very long time,” said Farrelly. “It is particularly significant against boring old bonds, which everyone says are a joke,” he added, referring to the fact that Japanese bonds have outperformed equities over the last 10 years.

Using his formula (income + growth in income +/- the effect of change of the price earnings ratio), Farrelly asserted that bubbles were identifiable. He demonstrated that over a 10-year period US REITs had a 0.9 per cent annual return.

“This [was] clearly a bubble, had to go wrong, and obviously did,” he said.

Also using that formula, he showed that as at October 2000 the 10-year forecast for US equities was an annual return of 1.5 per cent, and Japanese equities were forecast to have a 10-year annual return of -3.3 per cent as at December 1988.

“These bubbles, at their peaks, are absolutely identifiable,” he said. “[The formula] is not necessarily enough to get out of the way but it’s a useful starting point.”

Farrelly admitted that bubbles were hard to spot, as the time to peak was difficult to predict and varied enormously between asset classes. For example, US REITs looked expensive as far back as 2004 before its peak in 2007, he said.

“When things start to look expensive, you just don’t know when they’re going to turn,” he said. “So stay away. This demands courage — the choice is clear but it’s not necessarily comfortable.”

Farrelly said the new imperative in asset allocation was that bubbles were a permanent part of the landscape, adding that a current bubble was gold.

“If you buy [gold] today you will lose a lot of money,” he said.