How to spot a financial bubble and why Tesla looks vulnerable

Despite their frequency in the history of financial markets, investors are notoriously bad at spotting bubbles.

Pick up a book on financial history and it is likely to mostly be a story of financial bubbles, from 17th-century Dutch Tulips to 21st-century American houses.

Yet despite their frequency in the history of financial markets, investors are notoriously bad at spotting bubbles. They must be, or else, by definition, bubbles in asset prices would not exist. 

Part of the problem, however, is there being no accepted definition of a bubble. Having some idea of what actually constitutes a bubble should give investors a better chance of identifying bubbles (of course were the identification of a bubble to be widely accepted it would end the bubble.)    

A new paper by Research Affiliates reviews the current state of several assets they have previously identified as bubbles based on their own definition.   

Research Affiliates describes the first component of a bubble as the unmooring of price and fundamentals of an asset. They identify this as an asset which, according to any generally accepted definition of value and plausible projection of future cash flow, appears so expensive it has little hope of producing a return higher than that of bonds or cash. 

The second part of the definition explains why anyone would still want to buy an asset with such seemingly bad return prospects (and hence making it a bubble): the buyer of the asset is ignoring generally accepted valuation models, buying on a poplar narrative and/or expecting to sell the asset on for a higher price. 

On this basis, back in 2018, Research Affiliates identified three potential bubbles: the global technology sector, in Tesla specifically, and in bitcoin and other cryptocurrencies. According to their new paper released this month, all three are still in bubble territory. 

Current valuations for large-cap tech stocks, the paper argues, suggests the sector is still potentially somewhere around bubble territory. 

They note that while large tech stocks – the FAANGs - are not necessarily bubbles themselves, to justify current valuations would require "aggressive, but not implausible, expectations for future growth."

And what of last year's heavy losses on the tech sector? The paper suggests it could be the beginning of the end for the potential bubble in tech. Such sharp downturns and rebounds are not an uncommon occurrence as a bubble unwinds. 

The paper notes:

"For example, the NASDAQ index plunged −36% from March 2000 to May 2000, only to gain back 35% by July 2000. Of course, this was a mere pause and final exit opportunity before the −58% drop between July 2000 and the October 2002 lows."

The paper is less ambiguous when it comes to bitcoin. While 2018 was an unremarkable year for the cryptocurrency (following 2017’s peaks), it has seen strong price recovery since the start of 2019, rising by around 180%. 

"Is this just volatility or a true bubble?" the paper asks before then outlining why it thinks bitcoin is in a bubble. The paper adds: "Consistent with our definition of a bubble, cryptocurrencies hold little chance of offering a positive risk premium relative to bonds or cash based on a reasonable expectation of future cash flows, which are by definition zero." Principally, any expectation of a higher price rests solely on the hope that a “greater fool” will be willing to pay the higher price. 

In 2018, Research Affiliates identified Tesla (NASDAQ:TSLA) as a "single-asset micro-bubble." The company was valued on the assumption that it will see explosive growth and profitability in the near future. Research Affiliates, however, argued that this expectation "has been the case for seven years reflecting an ongoing battle between expectations and reality." 

In reality, Research Affiliates argued, the electric car maker has little chance of producing the necessary cash flows to service its current debt, "let alone justify the valuation of its stock."

Tesla, the paper says, shows the challenge of predicting the evolution of bubbles. Expectations can be positive for years until sentiment finally turns. Research Affiliates think that the rest of the market is now catching up with their view, noting that the first quarter of 2019 was a "cold shower of reality."

They continued: "Over the first six months of 2019, Tesla's price fell 32% to $223. The share price first reached this level in January of 2016, so most investors since that time are likely underwater."

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.