Don't Fear the Bubble, Embrace It!

01/24/2020 9:02 am EST

Focus: STOCKS

Landon Whaley

Editor, Gravitational Edge

While there is plenty of talk regarding an equity market bubble, traders should remember that often the best profits opportunities occur during blow-off tops and reversals. There is nothing to fear, writes Landon Whaley.

If I allowed you to buy the NASDAQ 100 via the Invesco Nasdaq 100 ETF (QQQ) on Dec. 31, 1999, would you take that trade?

Most people would say, "No way!” Why would you want to buy an asset that was frothy just months before the bubble burst? I can think of two reasons: Bubbles don't pop in a day, and there are massive trading opportunities riding the waves of a bursting bubble.

Even if you sensed things were a bit ahead of themselves, you had no way of knowing that the peak would come on March 24, 2000. And if we've learned nothing else over the last decade, just because a market has gone up or down X% doesn't mean a bubblicious market can't move a lot further in that same direction. As we mentioned earlier this week, you can be right on a bubble but lose money missing on the manic blow-off tops.

Here is a breakdown of the opportunity set that QQQ provided during the bubble bursting year of 2000:

  • 12/31/1999 – 3/24/2000 = +32%
  • 3/24/2000 – 5/26/2000 = -40%
  • 5/26/2000 – 9/1/ 2000 = +43%
  • 9/1/2000 – 12/31/2000 = -44%

These advances and declines lasted anywhere from two to three months and provided a total opportunity set of 159%. I'm not saying anyone could have caught the top and bottom of all four pivots in real-time. I'm merely pointing out that there was ample opportunity (on the long and short side), lasting months at a time, in the aftermath of the bursting of one of the all-time biggest asset bubbles in U.S. history. Yes, catching a falling knife is dangerous, that’s why its better to let the market decide.

Even the buy and hold investor would have held up well owning the QQQs after the bubble got punctured. You could have purchased QQQ on Dec. 31, 1999 (after it had already gained 200% in proceeding two years) and made +32% in the first three months of your position, made 13% in the first nine months and still been at break-even when October 2000 rolled around.

From a Fundamental Gravity perspective, the U.S. toggled between Fall and Summer from mid-1998 until Q2 2000. There is no more conducive environment for the Nasdaq 100 than Summer or Spring, and as we'll discuss in a moment, a Fall Fundamental Gravity is a suitable environment for getting long the QQQs as well.

The point here is, don't fear bubbles and don't avoid markets altogether because some people are calling them bubblicious. Bubbles don't pop overnight, and once burst, it takes time for those markets to work off the excess, and this "working off" period has many tradeable trends.

The 2008 Bubble

The Financial Crisis in 2008 was no different. QQQ declined 20% in the first three months of the year, gained 23% over the next three months, and then declined 47% over the next five months before rallying 12% during December. These are four massive price movements that occurred over a minimum of four weeks to as long as three months, which means there was ample time to get involved strategically. Again, I'm not suggesting anyone could have nailed every pivot in the Nasdaq 100 during the crisis. However, what I'm articulating is that no matter how you were positioned heading into the crisis, you had multiple chances to get out or to reposition your portfolio opportunistically. The moves were so significant that you didn’t need to catch it perfectly to make money.

Leading up to the crisis, the U.S. economy moved between Fall, Spring, and Summer FG environments from Q4 2006 until Q1 2008. You could have been opportunistically long the Nasdaq 100 during those 15 months, captured some portion of the QQQ's 28.1% return, and still moved to the sidelines before Winter set in and the real wealth destruction occurred between August and November 2008.

Today's Bubble

To bring this conversation full circle, let's discuss the current state of the Nasdaq 100 (QQQ). Since the March 2009 lows, QQQ has rallied an impressive 835%.

Does an 11-year, 835% rally constitute a bubble? I don't know, and I don't really care. What I do care about is whether the current Fundamental Gravity is conducive to being long the QQQs, and the answer is "yes!"

During a Fall Fundamental Gravity, the Nasdaq 100 (QQQ) averages +2.4%, experiences a -10.4% drawdown, and is positive 61% of the time. Fall isn't the most favorable environment for Nasdaq exposure (that's Spring and Summer), but it's also not a time to load up on the short side either.

The Bottom Line

I'm not going to avoid a market just because it's up XXX% over some arbitrary time frame, and the world believes it's in a bubble. Your investing process should be the same after an 835% rise, or a 47% decline. My friends, that process entails applying the Gravitational Framework, aligning your portfolio with the prevailing Fundamental Gravity environment, and risking capital when the Mongoose (or your own market timing process) gives you the green light. Wash, rinse, repeat. Bubbles be damned!

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