How to Protect Yourself from a Stock Market Bubble

Back in October 2013, the penny stock trio of Blumont Group Ltd (SGX: A33), LionGold Corp Ltd (SGX: A78), and Attilan Group Ltd (SGX: 5ET) (then known as Asiasons Capital), saw their shares lose up to 96% of their market value in the space of three trading days.

In total, more than S$6 billion in market value was wiped out in that episode between the three firms.

The stunning event happened after the three companies had seen some equally stunning gains: Blumont rose from six cents a share in August 2012 to a peak of S$2.45 at end-September 2013; LionGold’s shares shot up by 50% in less than a month from 1 August to 27 August 2013; Attilan experienced a 200% gain in just 19 days from 1 September to 19 September 2013.

When the collapse happened, there was a huge controversy and questions were raised about the possibility that the trio’s shares had been manipulated (there’s an ongoing investigation related to the matter being held by the authorities).

While there was much anger and confusion amongst market participants when the shares fell (how could billions be lost in a matter of days!?), it would appear that such periodic episodes of insanity are not just confined to within Singapore’s shores.

Just last week, a trio of Hong Kong-listed companies, Goldin Financial Holdings Ltd, Goldin Properties Holdings Ltd, and Hanergy Thin Film Power Group Ltd, saw their shares collapse after enjoying spectacular run ups in prices (notice any similarity?).

The former two – Goldin Financial and Goldin Properties – saw their shares sink by more than 60% last Thursday after having climbed by more than 300% each since the start of the year. The drastic declines the two companies experienced saw more than US$22 billion in market value being wiped off.

Meanwhile, Hanergy’s shares were in a figurative free-fall last Wednesday with its shares down 47% in the space of just 24 minutes; in a similar manner to the other two firms, Hanergy’s shares had nearly tripled in price in 2015 before the debacle occurred.

The experience of the aforementioned sextet highlight some important lessons for investors:

1. “The stock has gone up” is one of the worst reasons ever to invest

You’d never know when a crash can happen and as you’ve seen, the declines can be swift and brutal, leaving you with scarcely any time to react. The risks are even higher when a rapidly-rising share has no business fundamentals whatsoever (more on this shortly) to support its price.

2. Extreme valuations can be a recipe for disaster

Here’re some relevant information about the sextet: Blumont and Attilan were valued at more than 500 times their trailing earnings shortly before that fateful period in October; LionGold had just S$230 million in shareholder’s equity and was loss-making, and yet carried a market value of S$1.42 billion at its peak; according to Bloomberg, the “two Goldin companies traded at more than 130 times reported earnings before the rout, while Hanergy had a multiple of 65.”

Turns out, all six companies had carried ludicrous valuations and while there’s the possibility of unsavoury machinations going on behind the scenes leading to their sharp crashes (and gains), the presence of inflated stock prices alone can be enough to bring undeserving shares back down to earth over time.

As the legendary investor Benjamin Graham was believed to have said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” The weight of a stock (its business fundamentals) matter at the end of the day.

3. Bubbles can pop up anywhere – it pays to be careful

As I mentioned earlier, it may turn out that there were distasteful things happening behind the scenes with the sextet. But, it’s also true that bubbles in stock prices can also happen anywhere in the world purely due to animal spirts alone.

A famous episode is the dotcom bubble in the U.S. which occurred in the late 1990s and early 2000s. But, it’s quite possibly a belaboured example, so let’s move onto something fresher or less discussed:

  • In 1989, Japan’s Nikkei 225 Index, a broad market index akin to the Straits Times Index (SGX: ^STI) we have here, peaked at more than 38,900 points and was valued at around 100 times its historical earnings – an entire market had seen its valuation go off the charts. Today, the Nikkei sits at 20,000 points, nearly 50% lower than its 1989-high.
  • Earlier this month, a Chinese real-estate outfit called Shanghai Duolun Industry changed its name to P2P Financial Information Service. Its shares promptly rose by the daily limit of 10%.
  • Then, we have Singapore’s local business newswire The Business Times publishing an article today which stated that the “ChiNext, the small-cap board [for Chinese stocks], has a trailing price to earnings ratio of 90, more than double that of Internet stocks at the peak of America’s dotcom bubble in 2000.”

It’d be interesting to see how the situation in China develops because while valuations may look stretched in certain areas, excesses can carry on for far longer than we can imagine. Like the great economist John Maynard Keynes once said, “The market can stay irrational longer than you can stay solvent.”

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.