Investing in a bubble
INVESTORS who have invested long enough in stock markets would inevitably have encountered a bubble or a crash. Stock markets are prone to boom-and-bust cycles as investors are influenced by extreme greed and fear from time to time.
Can investors identify a market bubble in advance? What should they do in a bubble?
Can a bubble be identified ahead?
In the wake of the bursting of the Internet bubble in 2002, Alan Greenspan, then chairman of the US Federal Reserve, famously said: “It was very difficult to definitively identify a bubble until after the fact – that is, when its bursting confirmed its existence.”
I guess his remarks are not very helpful to investors. How about the opinion of market practitioners?
Howard Marks of Oaktree Asset Management defines bubbles as extreme bull markets. He opines that there is a bubble when investors are willing to pay any price for the asset. The words “no price too high” spell the essential core – and are the hallmark – of all bubbles.
Jeremy Grantham of GMO Asset Management further thinks that in addition to price, there has to be a surge of speculative interest among investors.
BT in your inbox
Start and end each day with the latest news stories and analyses delivered straight to your inbox.
Are these conditions currently prevalent in the US stock markets?
Here is another piece of evidence for consideration. In late 2023, Jim Chanos, Wall Street’s famous short-seller (or bear), decided to close down his hedge funds after almost 40 years in business. His firm’s assets under management (AUM) had declined from about US$8 billion in 2008 to less than US$200 million at end-2023. What does that tell us about the state of the market?
By the way, there is usually a tug of war between bulls and bears. A bull is by nature someone who thinks that prices will rise and act accordingly, while a bear thinks that prices will fall and likewise act correspondingly.
In his book The Wisdom of Crowds, James Surowiecki opined that the market usually gets the prices right when investors are mostly independent, diverse and decentralised. Hence the “wisdom of crowds” works.
In my opinion, when there is no bear left, it means that the bulls are thoroughly in control of the market and investors are no longer independent and diverse. As a result, markets tend to get prices wrong when investors go in a herd – as in a bubble.
As Surowiecki pointed out: “The measure of the stock market’s success is not whether stock prices are rising. It is whether stock prices are right. And it’s harder for the market to get prices right when there is so little money on the short side.”
The recent Chanos episode further reminds us of the case of Julian Robertson’s Tiger Hedge Fund. It was extremely successful in the 1980s and 1990s. During its heyday, Tiger Fund was in the same league as George Soros’ Quantum Fund.
During the Internet bubble in the 1990s, Robertson was extremely critical of bubbly tech stocks. He chose to ignore the tech sector and instead concentrated his bets on value stocks. However, investors had lost interest in value stocks. His firm’s AUM declined from about US$20 billion in 1998 to less than US$10 billion in just over one year. In the end, Robertson decided to close down his funds in March 2000, which incidentally marked the stock market peak.
Why is a stock bubble so scary? This is because implicit in a stock bubble is the expectation that it will eventually burst, with severe repercussions such as market plunges, credit crunches and massive wealth destructions. However, it does not mean that markets are subject to an imminent decline. As we know, the Internet bubble lasted for quite a period from 1995 to 2000.
If we are in a bubble, are we in the early or late phase of one?
What should investors do if there is a bubble? Should investors just sidestep the bubble, short the bubble, or ride it, with or without safety belts?
What should investors do in a bubble?
According to Wharton professor Jeremy Siegel, famed author of the classic, Stocks For the Long Run, investors should just step back. In another of his books, The Future for Investors, he advised: “When you (have) identified a bubble, step back and stop investing in the companies or sectors involved. If you should be so lucky as to hold some of the stocks that are caught in the frenzy, cash in your profits and don’t look back. The stocks you sold will probably rise further before they collapse, but in the long run, you will come out way ahead.”
This view assumes that investors are willing to sit on their hands or happy to part with a sizeable gain even if the markets continue to soar.
Should investors short the market? The problem with a bubble is that it can go to extremes, and far longer than investors can imagine. As the famous economist John Maynard Keynes put it: “The markets can remain irrational longer than you can remain solvent.”
Can we then have some cues from professional and sophisticated institutional investors?
The problem is that professional money managers often knowingly ride the bubble until it is too late.
As the unprecedented US housing bubble crisis was unfolding in the US, Charles Prince, then CEO of Citigroup, said on Jul 9, 2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We are still dancing.”
Oaktree Capital Management’s Marks later commented on this episode in his Nov 10, 2009, memo: “Prince seems to have been more aware of what was going on than people give him credit for. He may have sensed the bank was on thin ice in lending and levering, like the rest. The problem wasn’t that he overlooked the danger; the problem was that he felt he had to participate anyway. One of the dilemmas faced by businesses is that they can conclude that they have no choice but to take part in dangerous behaviour. Usually, this is because they’re unwilling to cede market share.”
So, what should most investors do in a bubble?
Should investors just buy and hold stocks and stay invested? Sure, but one never knows if a seeming temporary selloff will turn into an extended market decline and hit investors hard as in a bubble. For instance, the severe stock declines in 2000-2002 and 2008-2009 actually took investors quite a number of years to recover their losses, if at all.
Should investors use “trend following”? Trend following helps investors to stay invested during a bubble and to mitigate losses after a bubble bursts. It then helps investors to stay dry and get back to the market only after the trend has turned. In this way, investors can continue to reap the compounding returns. As Charlie Munger, Warren Buffett’s right-hand man, put it, “The first rule of compounding is to never interrupt it unnecessarily.”
Yes, trend followers will be subjected to whipsaws from time to time, which means investors getting in and out of an investment in a relatively short time before the actual trend has been established. Just think of it as a form of insurance protection against some tail-risk events.
By the way, for investors who hold individual stocks, your stocks might have treated you very well by going up “a few folds” in a bubble. You might think of holding on to your stocks for the long term as your investment thesis seems to have remained intact.
Well, you need to remain dispassionate and be objective. If you use a trend-following approach and your stock’s price is below the trend, sell. You can always buy the stock back later if the stock price rises above the trend again. You might have tonnes of reasons why your stock price will continue to go up and the selloff is just temporary. You might well be right – but just follow the trend. Remember never to fall in love with your stocks. I learnt this lesson the hard way.
The writer is a private investor. He was previously a researcher at an international business school in Europe and an Asia-Pacific director at multinational corporations