Gold, China, and Facebook: Detecting Market Bubbles

It's not always so difficult to know when an asset is in a bubble. The real challenge is determining when it will pop.

Suppose we can travel back in time and detect all the market bubbles that went bust. How much pain would we save ourselves? How much wealth would we forgo?

Vikram Mansharmani, managing director at Boston-based hedge fund SDK Capital, thinks he has nailed the formula to detect bubbles. He has laid out some obvious and admittedly quirky signs of market bubbles in his first book, Boombustology: Spotting Financial Bubbles Before They Burst, which was published this month.

I caught up with this self-proclaimed "boombustologist," who taught an undergraduate seminar at Yale called "Financial Booms and Busts." We discussed the five signs of a market bubble, a few potential bubbles today and the biggest one that is due to burst very soon: China's real estate market.

How do you spot a bubble?

There are five lenses. The first is a situation where there is a self-fulfilling dynamic going on -- when asset prices are rising rapidly and it's usually fueled by credit at the same time. A classic case would be the housing market, where a bank lends money to someone and that creates a new buyer. In securing the loan, the buyer drives up the price of the collateral. The bank then feels more secure, potentially even smart about its decision. So then it issues more loans, thereby creating more buyers to drive up the prices of real estate that are securing their loans.

The second is looking at the cost of money, how it's allocated and whether there is overcapacity. The South China Mall in southern China is a great example. It was designed for 1,500 tenants. As of last year, I think they had a dozen tenants. The president of the shopping mall was recently interviewed by Bloomberg, saying he would continue expanding the mall, despite it being 90-something percent vacant.

The third is overconfidence. Are we seeing signs of hubris? One indicator that I love to point to is the world's tallest skyscraper, because it signals a speculative instinct. Skyscrapers are never built by their intended tenants. It's usually a developer who is hoping to attract tenants after the building is complete.

The tallest building in the world today is the Burj Khalifa in Dubai, which has been bailed out by the government of Abu Dhabi. So if you look forward at where the world's tallest towers under construction are today -- five of the 10 largest towers under construction are in China.

Also, watch for spikes in Sotheby's (BID) common stock prices. This also signals overconfidence. Over long periods of time the price of the art auction house has generally been around $15 to $25 a share. In 1990, it rose considerably. If you look back and listen to what they were saying about the markets at the time, it was that world record art prices were being set left and right by Japanese buyers.

In 1999 we had another surge in Sotheby's stock price driven by a couple of things. For one, we had Internet buyers, and two, Sotheby's launched Sotheby's.com, so it played into the mania that was going on. In 2007 we had Russian billionaires, hedge fund managers, private equity executives all driving the art markets.

Sotheby's stock price reflected that and it spiked back up. It fell back down immediately after that bubble imploded.

Today Sotheby's stock is elevated once again and it's being driven by Chinese art buyers.

What do you think is the biggest bubble today?

China's economy. It exhibits all the tell tale signs that have characterized all the great speculative manias throughout history. We have reflexive dynamics under way that are self-fulfilling. Look at property prices -- they're rising rapidly, driven by increasing amounts of credit. It's not an overly leveraged situation yet, but it's increasingly so.

There's also misallocated capital. We can see this, for instance, with South China Mall and the skyscrapers under construction. And then there's the moral hazard factor. A lot of state-run banks are lending money to projects because they're told to politically -- not because they're economically rational projects to lend against. We have state-owned banks lending money to state-owned enterprises to buy land from the state. How we can possibly think that's market oriented and not self-dealing is confusing to me. It's all funny money.

If there's a bubble in China, when do you think it will pop?

The reality is that we have signs that it's getting increasingly mature. I would be very shocked if it didn't manifest itself in the next three to five years.

What are some of the possible bubbles you see in the U.S. today?

Gold. Everyone has an opinion about gold. That by itself indicates that it's quite bubbly. Now, you ask, what are the signs? We have to ask are there any financial innovations that allow for embedded leverage to take place in gold? Absolutely. We have these Exchange Traded Funds (ETFs) that allow anyone to buy gold and have increased speculative tendencies in that market. Also, you have to wonder if gold is over-popularized. I don't know about you but even as I walk through New York City I find signs of people offering to buy gold and sell gold. And perhaps the most interesting phenomenon is that there are now gold vending machines. They have it in Dubai and a couple of other places but they've now introduced them in the United States.

Another potential bubble is the social networking industry. It's very loftily valued. I don't know if it's a bubble or not but I'm telling you some reasons for why it could be bubbly. In the Internet era, there's some thinking that earnings don't matter, it's eyeballs we want -- we want website traffic, we don't care about cash flow.

So with Facebook today being valued at $50 to $60 billion it's hard to answer the basis for that. It's a new industry -- it's social networking. How do you value that? Because it's not well established you have the possibility of any valuation metric you choose. So lacking that valuation anchor results in a bubble potential.

Prices for many commodities are rising -- are these bubbles?

There are some commodities -- iron ore, zinc, lead, cotton, soybeans -- where China is a massive portion of the demand, making up 40%, 50% and sometimes even more. Given my China perspective, I think they're quite vulnerable and potentially prone to a bust because in the quest to meet this growing Chinese demand they've grown their capacity even faster and a slowdown in China will result in massive overcapacity in those complexes.

What's not a bubble?

Energy is something I'm quite bullish on. China today represents 10% or 11% of global oil demand. It's actually not that large. It's a large percentage of the growth in oil demand, but it's that large of a percentage of overall oil demand. It's harder to find, it's in more difficult places -- geopolitically and technically. It's one of the few resources today that is well suited for transportation purposes. And so given those dynamics I think oil is not in a bubble. Will it have ups and downs along the way? Sure. There will be people who will speculate in the futures markets and drive it up short-term but it will come back. But fundamentally we have a scarce resource in oil.