The Flip Side of Market Bubbles

The Bubble Index In early 2017, Bloomberg editor Joe Wiesenthal tweeted, "A good ETF would be to take companies/markets that journalists say are in a bubble and then to go long them." A portfolio manager at the investment firm GAM, Paul McNamara, took up the challenge, and created a hypothetical portfolio of oft-derided securities. Among them were Tesla TSLA and Netflix NFLX, a bitcoin fund, long bonds, a Chinese real estate trust, and an exchange-traded note that shorted U.S. stock volatility.

The Bubble Portfolio gained 80% for the rest of 2017, dropped 23% the following year (its short-volatility note liquidated after losing more than 90% of its value), and has rebounded to gain 17% so far this year. That makes for a 25%-plus annualized return (I can't state precisely, as I don't have the portfolio's official start date), albeit with some significant variability.

Ink-Stained Wretches The media, cannibals that they are, did not miss the opportunity to consume their own. CCN's Mark Emem wrote, "If the bubble portfolio serves any useful purpose, it is to prove that the mainstream media gets it mostly wrong when it comes to picking overvalued assets." ForexTV.com stated, "Here's what happens when you buy assets that journalists warn are in a bubble." Bloomberg's Matt Levine asked, "What on earth do journalists, no offense, have to recommend them?"

No offense taken, Matt. I couldn’t have said it better myself.

However, the trail is false. This tale is about investment professionals, not the media. Because journalists, by and large, aren't inventing these arguments. (They certainly aren't building spreadsheets of Chinese real estate transactions.) These "bubbles" come courtesy of traders and portfolio managers. Confesses the Bubble Index's creator, McNamara, "You'd be nuts to buy any of this stuff here."

Long-Term Malaise Which leads to the question: Is there money to be made from inverting the professional consensus?

Not, it would seem, by buying and holding. Over the past 30 years, these have been the most-heralded bubbles:

1) Japan, 1980s

2) The New Era, 1990s 3)

Long bonds, 2010s

(Real estate, 2000s, was also lamented, but almost entirely after the fact. Cryptocurrencies could perhaps be placed on this list--but the skeptics mostly arrived in late 2017, when bitcoin traded, roughly speaking, at its current level.)

Japanese stocks have been a monumental, four-decade failure. The New Era stocks cratered at the start of the New Millennium. While they subsequently rebounded, they required another 15 years to catch back up with the rest of the U.S. equity market. Long bonds have so far resisted their predicted implosion, but they haven’t minted money, either.

Buying the professionals’ biggest sells flopped as a strategy because the obvious bubbles are, in fact, obviously unappealing acquisitions, to those who abide by the numbers. At a price/earnings ratio of 60, Japan’s national telephone utility figured, at best, to tread water. It wasn’t going to grow rapidly, and it already traded at an earnings yield of less than 2%. Also uninspiring were relatively mature New Era companies carrying price/earnings ratios above 100, or Treasury bonds yielding 2.5%.

There is, however, a difference between unappealing and imminently dangerous. It’s one thing to recognize that paying steep prices for assets with moderate-to-nonexistent growth rates is unsound. It is quite another to predict doom. No alleged bubble, in my experience, has been so glaring and self-evident that it must inevitably lead to collapse. (This is why I have yet to publish a “This is a bubble” column, and likely never will.) The most that we can state about the investment is that it is best avoided.

Short-Term Health? That advice may differ for bubble-related trading strategies. Investors in 1986 who bought Japanese stocks for the long term fared poorly. But those who purchased them for 12 months, with the plan on keeping their position if the market stayed strong but exiting if it slumped, would have soared for four years, been clocked with a huge loss in the fifth, and closed out their trade with a tidy 12.7% annualized return. Using a similar tactic with New Era stocks would have been more profitable yet.

This finding is not surprising. "Bubble," after all, is but another way of saying "investments with positive price momentum"--and investments with positive price momentum enjoy a long, long history of success. The broadest study ever conducted on investment behavior, spanning more than 200 years across 68 asset classes and 16 countries, concluded that price momentum was the strongest of the 24 factors that the authors evaluated. It had the greatest persistence, over time, asset types, and nations.

Thus, there is reason to believe that trading “bubble” investments might be effective. Whether it would improve upon other momentum strategies is another matter. It surely would be more volatile. It could be that those extra jolts accompany extra returns. Or maybe not.

Ultimately, it may not be possible to tell. McNamara writes that his Bubble Index comes from the back of a metaphorical envelope, as opposed to being an “actual investment methodology.” Putting rigor into the concept, so that unambiguous rules create the portfolios, would be a difficult task--perhaps too difficult ever to be accomplished.

Summary Both parties, in their own way, are correct. The mainstream investment community--as voiced by their messengers, journalists--does well at identifying those unusual instances when, to use McNamara's term, market valuations are determined by "passionate idiots" rather than dispassionate math. However, in calling those valuations "bubbles," the community implies that it knows more than it actually does. The critics are correct that these bubbles may not deflate immediately, or indeed ever at all.

Perhaps profits even can be made the label of “bubble,” by riding the coattails of price momentum. If such a fund existed, I would not buy it. But neither would I condemn such an approach, for those who understood the logic behind the investment and who were in position to accept its considerable risk. I have not heard many stranger ideas than buying into investment bubbles--but I have heard worse.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.