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How to Profit From the Biggest Bubble of Them All

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Originally posted on https://investmentu.com/market-analysis-profit-financial-bubbles/

 

When investors ask me, “Are we in a bubble?” I always give the same unsatisfying answer: “It depends.”

That’s because the picture is mixed. Some markets are partying like it’s (still) 1999. Other markets have not been this cheap since most Wall Street brokers were in diapers.

Today, a wide variety of “microbubbles” dot the financial landscape. Microbubbles include everything from privately held Silicon Valley unicorns to cryptocurrencies to the share price of Tesla (Nasdaq: TSLA).

But today, I want to focus on the prospects of what just might be the biggest bubble of all: the U.S. stock market.

What Is a Bubble?

For an asset to be in a bubble, two things must hold.

First, the asset must be overvalued, according to conventional measures of value. Investors ignore all historical comparisons.

Second, the price of the asset must stay irrationally high. Investors believe they can always sell the asset to a greater fool for a higher price tomorrow.

Today, both conventional measures and historical comparisons tell us that the U.S. stock market is in a bubble.

The cyclically adjusted price-to-earnings (CAPE) ratio popularized by Yale professor Robert Shiller looks at long-term valuations.

Based on the CAPE ratio, the U.S. stock market has been higher only twice in history: at the peak of the dot-com boom and just before the crash of 1929.

(No wonder the Yale endowment has allocated a flimsy 2.75% of its funds to U.S. stocks.)

As in the dot-com boom of the 1990s, technology is driving the current U.S. stock market bubble. Buzzwords like “disruption” and “blitzscaling” echo the “new economy” slogans of the dot-com era.

In 2000, investors focused on the “four horsemen” of technology Microsoft (Nasdaq: MSFT), Cisco (Nasdaq: CSCO), Intel (Nasdaq: INTC) and Dell (NYSE: DELL) because of their remarkable influence and appreciation.

Investment firm Research Affiliates tracked the fate of yesterday’s dot-com darlings after the bust. The results were sobering.

At the start of 2000, the 10 largest tech stocks in the U.S. market represented 25% of the S&P 500 Index. But each of these stocks Microsoft, Cisco, Intel, Dell, IBM (NYSE: IBM), Oracle (NYSE: ORCL), Qualcomm (Nasdaq: QCOM), HP (NYSE: HPQ), AOL and Sun Microsystems failed to live up to investors’ lofty expectations.

Over the subsequent 18 years, not a single one beat the market.

Five generated positive returns averaging a flimsy 3.2% a year. For the five that produced negative returns, the average loss was 7.2% a year. Hardly an inspiring performance.

How does all this apply to today’s market?

We know that all bubbles burst. And history tells us that what lies ahead isn’t pretty.

At the end of January 2018, seven of the largest stocks in the world were tech stocks: Alphabet (Nasdaq: GOOGL), Apple (Nasdaq: AAPL), Microsoft, Facebook (Nasdaq: FB), Amazon (Nasdaq: AMZN), Tencent (OTC: TCEHY) and Alibaba (NYSE: BABA).

If history repeats itself, each of these tech titans will underperform the market over the next 10 years.

A Bubble Investing Strategy

So what is an investor to do?

First, you can stay out of the market altogether. Just accept that timing the market is a mug’s game.

As Isaac Newton observed after losing his fortune in the South Sea bubble, “I can calculate the motions of heavenly bodies, but not the madness of crowds.”

Second, you can bet against the bubble by shorting expensive assets.

Sir John Templeton made his quickest fortune betting against dot-com stocks in late 1999.

Mark Cuban preserved his billion-dollar-plus payday from Yahoo by shorting Yahoo’s stock.

Still, it’s worth remembering that despite boasting price-to-earnings ratios in the triple digits, stocks like Netflix (Nasdaq: NFLX) and Amazon have been among the market’s top performers over the past decade. Shorting either stock would have put Templeton and Cuban out of business.

Third, you can invest in what Research Affiliates calls “anti-bubbles.” Anti-bubbles are assets and strategies that are, by all historical measures, massively undervalued.

Today, international and emerging market stocks are trading at half price compared with U.S. stocks. And the gap between growth and value strategies has never been wider.

However, the anti-bubble strategy is the strategy of investors like the Yale endowment that have an infinite time horizon.

No matter which strategy you pursue, you must be patient.

Bubbles typically continue longer than most investors expect. And bubbles tend to burst with startling speed.

Whatever you choose, strap yourself in for a wild ride.

As the Wall Street adage warns, “The bull walks up the stairs and the bear jumps out the window.”

Good investing,

Nicholas

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