Investors and pundits alike have started to contemplate the dangers of a ‘bubble’.

“Are we nearing bubble territory?” my daughter Dorothea asked me over lunch. This sounds a wee bit precocious for a 22-year-old, even for someone who is graduating in economics this weekend.

Yet she is not alone. After many years of stellar recovery from the devastating effects of the 2008 financial crisis, investors and pundits alike have started to contemplate the dangers of a ‘bubble’, meaning the over-heating of markets with a possible crash on the horizon.

Economic theory has great difficulties to explain investor exuberance, pushing up prices be­yond the reasonable. Markets are supposed to work efficiently, pricing assets unfailingly. In theory, there is no bubble.

And yet, “what goes up must come down”, warns the old adage, and “be fearful when others are greedy”. Breakdowns of markets are imminent precisely because humans are not acting as rationally as theory wants us to be.

All attempts to measure asset inflation is as scientific as reading tea leaves. Traditionally, shares are evaluated according to their earning power, the ‘price/earnings ratio’, dividing the market capitali­sation of a company by its profits.

If a company is valued only a couple of times higher than its yearly income, it is considered cheap. When the price of an enterprise is so high that decades of profits will never suffice to recover the initial investment, the company is regarded as too expensive.

The same ratio is often applied to stock markets as a whole. Most professionals view a ratio of 15 as danger territory. Below that you can relax, above it some nervousness is called for.

Applying this crude yardstick to the NY stock exchange now, we all face certain extinction: at the be­ginning of June the average P/E of all companies represented in the S&P 500 index approached 26.

Many professionals in the asset industry turn a deaf ear, which is understandable. Investing other people’s money is their business, and their interest to scare inves­tors off is therefore limited. Shares may be expensive, their sales pitch goes, but not too expensive yet.

Strictly speaking, their thinking is not entirely unreasonable. If a company makes a net profit of five per cent per share (which a P/E of 25 implies), it can theoretically pay out 60 per cent in the form of divi­dends. Which means that buying the shares of the company at current prices will still yield three per cent per annum, or 40 per cent more than US government bonds.

We will never see it coming. Nobody will

Future growth is not even contemplated in this calculation, and neither is a timely boost to earnings. Many companies in the S&P index today don’t make much profit at all. Think of Amazon or Tesla, with their huge investment programmes diminishing all current profits. Or oil and mining companies, whose profits are depressed by weak commodity prices. They are all major constituents of the index, and therefore inflating the price-earnings ratio to painful levels.

Another argument often stressed to calm investors’ nerves is the eternal profitability of the stock market. Stocks may be volatile and unpredictable in the short term, but will reign supreme over long-term periods.

“The Standard and Poor 500 in­dex has an average return of seven to 12 per cent per annum,” we hear, calculated over a century, including the Great Depression, two world wars and numerous other wars and crises. The indisputable part of this theory is that shares do not qualify at all for someone who cannot sit out at least 10 bad years while watching his fortunes return to dust.

The disputable part of the argument is the lure of compounding and the attraction of the long-run. If one invested one cent and doubled this investment every day, one would have made 10 million in 30 days, you know? The sad thing is that in the long run we are all dead, as the economist John Maynard Keynes quizzically observed, no matter how profitable.

The other caveat is the composition of the index itself. Not only will we die in the long run, companies will perish too. Remember Eastman Kodak, Woolworth or Union Carbide? The stock market will grow for sure over the centuries, but its constituents will not necessarily. Otherwise we would still invest half of our money in railways and not in electronics and the internet. So if you stick with your railways, not even centuries will boost your returns, quite the contrary.

To sit it out might be a dangerous proposition too. On December 29, 1989, the Nikkei 225 index, comprising proud names like Toyota, Mitsui and Sony, reached 38,915.87. Today, almost 30 years later, the index has reached 20,177 (June 2). And the Italian stock exchange, Milano Italia Borsa, after a successful year, still stands 60 per cent lower today than in March 2000. A rather long time to wait for your savings to recover.

Bubbles build and bubbles pop. No politician can help it. Eventually the music will stop and all chairs will be taken.

It is just impossible to predict when the next crash will happen. It may be in another nine years from now, or next month. Nobody can tell. And equally, after the crash happens nobody will know when the worst will be over and markets will go up again.

So it is not wise to sell in panic and wait on the sidelines for the right moment. We will never see it coming. Nobody will. Statistically speaking we will always sell too early and buy too late. Therefore, it is better to stay calm and carry on.

A good investment approach is not to throw everything overboard but change proportions of your investment, in incremental steps over time. More cash in times of crisis, for instance, more stocks when times look more promising – and cheaper.

Dorothea, in answer to your question: I see a bubble, you are right, but I am not quite sure yet what to think of it.

Andreas Weitzer is an indepen­dent journalist based in Malta. He reports on the economy, politics and finance. The purpose of his column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice or advice on the buying and selling of financial products.

Please send in any suggestions for discussion in this column to: editor@timesofmalta.com – Subject: Sunday Times Personal Finance.