What's the Big Deal with Bubbles?

01/20/2020 10:12 am EST

Focus: MARKETS

Landon Whaley

Editor, Gravitational Edge

Many people are talking about an expanding market bubble, but bubbles can persist, so it’s best to align yourself with the economies Fundamental Gravity, writes Landon Whaley.

With the Dow hitting 29,000 and Tesla (TSLA) breaking through $500 per share, there is no shortage of blog posts, manager commentaries, and articles discussing bubbles. Most, if not all, of these articles, are written as “buyer beware” pieces that warn about the risks of buying into specific markets (or stocks) deemed to be bubblicious.

The problem is that what constitutes an asset class bubble is highly subjective, and it seems as though everyone has a different definition.

Some folks talk about current valuations relative to historical averages. For instance, based on various metrics, the S&P 500 is more overvalued right now than at any point in history. The problem with the valuation approach is that it’s only applicable to equity markets and is fraught with disagreement depending on which valuation metric one chooses to use.

Other people look at the magnitude and duration of a price move to indicate at what point a market has entered bubbly territory. This type of definition is also extraordinarily subjective and hard to quantify.

My favorite and the most absurd criteria for a market bubble is that “irrational exuberance” will be present. Perhaps irrational exuberance — the term coined by former Fed Chair Alan Greenspan during the market(dot-com) bubble of the 1990s — is like obscenity, and you know it when you see it. If not, how do you quantify irrational exuberance?

Even if we could all agree on a data-driven definition of a bubble, it would tell you nothing about when the bubble would pop or after it burst, how long it would take that particular market to work off the excesses and begin to rise once again. For example, many analysts correctly identified the bubble in the 1990s, but those who got out or got short missed out on the frothy top. Being right is an empty victory when you lose money.

My take on asset bubbles is entirely different. 

Do you remember the fun you could have with just a container of bubble solution and the bubble wand? If you don’t, you’re lying to yourself!

For my money, there were two things I enjoyed most about blowing bubbles, big magic bubbles. First, my competitive streak liked to see if I could be the one to blow the biggest bubble of all my friends. Second, once the air was full of bubbles, I loved sprinting around and popping as many as I could before they hit the ground!

Asset bubbles are no different. I like to see how big a market’s bubble can get, and I also love to see that bubble get pricked. Both provide excellent opportunities for high quality, risk-adjusted returns. At the end of the day, profits that come from an acceptable level of risk-taking are what matter, and the rest is just conversation.

I always laugh when these bubble articles start coming out en masse. I’m generally already long bubblicious markets because often, it’s a market that has been bullishly aligned with the prevailing Fundamental Gravity for quite some time.

For example, I’ve lost count of the number of research pieces I’ve read over the last two years, saying that utility stocks are in a bubble. I don’t know about you, but I’ll take the 36.2% return (with just a -8.9% drawdown) in utilities over the last two years as opposed to the underperforming 24.0% return with a filthy 19.3% drawdown in everyone’s favorite equity index, the S&P 500.

The flip side is when a bubble bursts, which typically occurs when a bullish FG environment for that bubblicious market shifts into a bearish FG. Look no further than crude oil during 2018. The U.S. was in a Spring or Summer environment for the first nine months of the year, during which crude oil gained 32.3%. However, when black gold ran into the Winter FG in Q4 2018, the bubble got pricked to the tune of a 38.1% loss, and an intra-quarter drawdown of -41.1%! Ouch!

The bottom line is that words like “bubble” and “mania” make for catchy headlines. Those words sell newspapers, get clicks, and entice the seven remaining people who watch CNBC tune in every day. Unless you’re trying to play Captain Market Top Caller, those words have no place in your investment process. Rather than spending time attempting to decipher if a market is bubbling over, align your portfolio with the prevailing Fundamental Gravity and let the economic and financial market laws do the rest.  

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