Don't get caught in the next bubble

We live in an age of bubbles. From the dot.com boom to the property market bust, via commodities, gold and emerging markets, one bubble relentlessly follows another. Bubbles crush economies and destroy fortunes when they burst. But they also make people a stack of money, if they get out in time. So how do you survive the age of bubbles? It began in Japan, in the 1980s. It was followed by a technology bubble in the late 1990s. Then the recent property situation.

At first, each calamity was treated as a one-off. But now many analysts are viewing them as part of the same cycle. In a globalised world there is always a huge amount of surplus liquidity flying around the world looking for a profitable home. It can switch countries and regions in minutes, even seconds, and nobody can stop it. After the Japan bubble was pricked in 1989, all that loose liquidity packed its bags and jetted off to booming east Asian markets, and after the 1997 Asian financial crisis it flew into technology. Then it alighted on property, and lately it's been journeying to Brazil, Russia, India and China, and decked itself in gold. At some point it has to hit a brick wall.

David Sanders, the chief investment officer at Invest AD Asset Management in Abu Dhabi, a firm that manages funds in the Middle East and Africa, spent five years in Japan where he witnessed the slow deflation of the country's bubble, which saw the Nikkei slide from 39,000 in 1989 to below 7,000 in October 2008. "The cause of the Japanese bubble was the same as subsequent bubbles: herd mentality and investor euphoria, allied to readily available cash and leverage."

Japan was hit hard because it suffered a stock market and real estate bubble at the same time. Investors convinced themselves this was justified by the country's new status as a global economic powerhouse. "They fell for the old mantra that 'this time it's different', but it never is," Mr Sanders says. So what can you learn from Japan's experience? "Pay close attention to share valuations. Look closely at the price-earnings [P/E] ratio, which is the market value of the share divided by the company's earnings. If a market typically trades at between 12 and 20, and the P/E ratio has leapt to, say, 50, that's a danger signal," Mr Sanders explains.

Ignore the hype, especially from the media. "Too many investors pile into a stock because they know somebody who has made a lot of money from it, often without knowing anything about the company. You must do your own research." Bubbles are inflating and bursting at gathering speed, says Dan Dowding, chief executive officer for the Middle East and Asia at independent financial advisers Killik & Co in Dubai.

"We've seen bubbles in Japan, dot.com stocks and property," he says. "Closer to home, we've had the Dubai property bubble, and some are suggesting China is also a bubble waiting to burst. "You used to get a major financial crisis every 60 to 70 years, now they come along regularly." Cheap money has driven the global stock market rally since March 2009, although Mr Dowding doesn't believe Western stock markets are in a bubble yet.

"Share valuations have recovered from extremely oversold levels, and while they're no longer cheap, they aren't expensive, either." To succeed in a world of bubbles, investors must be disciplined. Careful asset allocation helps, which means spreading your money across shares, bonds, cash and property, and different markets and sectors, so that you won't be overexposed to a bubble sector. "Timing your entry into the market, using your common sense and taking a long-term view will also prevent you from getting caught out," Mr Dowding adds.

The riskiest thing you can do is borrow to invest, says Steve Gregory, managing partner at financial services company Holborn Assets, based in Dubai. "This is called gearing, and is particularly dangerous, because if your investment goes wrong you owe the bank money," Mr Gregory explains. "You can lose more than you actually have." Gearing to invest in off-plan property is particularly dangerous, as many in Dubai have discovered.

"When it works, you can double your money. But when the bubble bursts, your property is worth less than the price you contracted for, and you owe the balance," he says. So why did people take such risks? Mr Gregory blames our old friends fear and greed. "Investors were driven by fear of rising property prices, fear of increasing rents, and fear of failure," he says. "Others were greedy, and were left holding pieces of paper showing ownership of up to 16 properties they never intended to own, but now have to pay for."

Timing is crucial when markets are rising. "Your maxim should be, buy low, sell high. This means defying the herd. When things are cheap, they deserve your interest. When they are expensive, look for something offering better value." And don't get out of your depth. "I wouldn't invest in stocks unless I had the time and money to make a full-time job of it; it requires too much research and analysis to go it alone." If you buy mutual investment funds, don't chase last year's top performer, Mr Gregory says.

"Funds investing in Russia are showing profits of up to 200 per cent in the last 12 months," he says. "That is unlikely to happen this year. Brazil was another star performer that is unlikely to repeat the feat. Investment goes in cycles. Last year's losers are often this year's winners." Easy credit is the mother of all bubbles, says Michael Small, partner at UAE-based financial consultants VSM Consultancy.

"It has created bubble after bubble after bubble. The recent boom was built on leverage, with people borrowing money to invest and create more wealth, but those days are now over," Mr Small says. "People are repaying money if they can, and borrowing less." Rock-bottom interest rates have spared the global economy the worst of the pain, he adds. "Central bankers have been deferring the pain for years. We should have had a large recession in 2000 due to the massive amount of capital lost in the dot.com implosion, but didn't, thanks to low interest rates. But the cycles are getting shorter and the end problem is only getting bigger." Mr Small says bond-market vigilantes are now picking off the weakest countries, one by one.

"Most people laughed off Iceland's troubles. The Baltics didn't affect anybody," he explains. "Ireland brought the problem closer to home, then people forgot about it. When the crisis reached Dubai, the world stopped for five days, then got over it. "Now we are worried about Greece. Each collapse is a bit bigger than the last one, and who comes next? Probably Portugal. Then perhaps the UK." VSM Consultancy specialises in risk management, protecting its clients' portfolios from future market dangers such as bubbles.

"We put our clients into gold five years ago and they have done extremely well. Last year, we took them out. We think gold is now a bubble; most people holding it are speculators rather than investors." Mr Small also pulled his clients out of investment properties. "Property will fall as the West continues to deleverage and interest rates rise. We are taking our clients out of property in Spain, Ireland, the US, UK and Dubai. London hasn't collapsed like we feared it would, but there is still time if the UK bond market comes under attack, as we suspect it will."

If the price of an asset bears no relationship to reality, you have a bubble. "When you are paying £300,000 to buy a scruffy little shoebox in London, things have gone too far. When you're buying a dot.com company at 700 times earnings, you are in trouble," Mr Small says. "Oil at $85 a barrel also looks like a bubble to me. If you took hedge funds, bank funds and proprietary dealing funds out of the market, the price could fall to around $40."

The age of bubbles has been fuelled by liberalisation of the financial system, he says. "There is so much deep-seated anger about the banking system, but it hasn't been turned into regulatory action, because the industry lobbying is too strong. "Maybe Goldman Sachs is the catalyst that will change that. It needs to be changed. "If not, we will soon be on the cusp of another calamity."