Over the recent few months the Nairobi Stock Exchange (NSE) has been on a bull ride. The bourse has seen record breaking highs in share prices and subscriptions of IPOs. Compared to its East African counterparts, the Uganda Securities Exchange (USE) and the Dar es Salaam Stocks Exchange (DSE), the NSE may be experiencing a ‘stock market bubble’ like the ‘dot.com bubble’ in USA bourses during the late 90’s, where prices of stocks shot up without any substantial reason.

A stocks market bubble is a massive rise in stock prices caused by a wave of public enthusiasm. This wave elicits a mass behavior that gives rise to an exaggerated bull market. Market prices of listed stocks consequently become overvalued. Generally, stock market bubbles are followed by stock market crashes.

Over the decades stock market bubbles have been experienced in many stock markets around the world. Each of them (like the great crash of October 29, 1929, prior to the great depression in northern America) leads to a crashing of the bourse with devastating effects on the country’s economy. Surprisingly, none of the crashes has ever been forecasted even by great economists. Just 14 days before the great crash of October 29, Irving Fisher, a distinguished Economist, said that in a few months he expected the market to be much higher than it was then, only for it to collapse in less than a month.

In Africa, due to lack of liquidity and the small market size, the bubbles’ size is either too small or has never been experienced altogether. Thus, many of the African stocks markets have never encountered a crash, Johannesburg Stock Exchange being an exception. This should not be a reason for us to throw caution to the wind.

For many traders and investors, the fear of a crash is a perpetual source of stress, and the onset of the event itself can be devastating. At the moment, this fear is slowly gripping investors in the NSE. Prices of stocks are rising not because of increased profitability of the listed companies but due to future prospects, fast increase in value, and anticipation of rise in prices. To make matters worse, investors buy the over valued shares using borrowed money.

With the impending integration of the three East African stocks markets, existence of a bubble in the NSE would not only affect all the markets, but also the regional economy. This would adversely affect the process or even stall it for good. There is need to look out for signs of a bubble in the three bourses and prevent them from bursting. The NSE should be wary since it is more active and at an advanced development stage.

Looking at the performance of the NSE over the last ten years, in the figure below, it is clear that the market index has never been this high and the probability of it dropping is more likely. The market index has hit an historic high of 5,654.46, which can easily be compared to the United States NASQAD (National Association of Securities Dealers Automated Quotations) index of 5,048.62 in July 2000 just before the ‘dot-com bubble’ burst. The question is, ‘Is the NSE trading in a bubble?’

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Nobody has ever predicted the ‘when’ and ‘how’ of bursts. Just before the burst, the market will always look so promising and attract some late comers. Unfortunately, they are hit the most. The NSE is exhibiting all these features. Almost all the listed stocks seem to be performing well. But something curious about them is that most of these stocks have a P/E (Price/Earnings) ratio of more than 22, meaning that, an investor will take 22 years or more to double his investment.  This is simply unrealistic and clearly reflects the existence of a bubble in the market.

The downturn of the market is quite eminent and investors should take measures to avoid incurring losses when this occurs. Some defensive measures that can be employed include changing the asset base of one’s investment portfolio. This involves moving out of stocks and equities as soon as you realize the change in trends and getting into high quality corporate bonds in companies that are going to survive no matter what and maybe some short-term treasury bills. One can also get into high-quality bonds and set oneself on auto pilot since they have a fixed rate of return although lower than what you will get from the stocks. Another option would be housing which at the moment is slowing down.

On the other hand, it may be alarming to say that the NSE is headed for an outright crash. It makes more sense to ponder on the idea that large investors such as mutual funds will start buying when prices of solid stocks fall to the point where they are undervalued, than thinking they will stay away and let the downturn run into a crash. At the moment, speculation in the NSE has not yet gone out of hand. Let's hope it just a breath and not a bubble.