Yes. It’s a Bubble. So What?

Investing

What constitutes a bubble?

  • We define a bubble as a circumstance in which asset prices 1) offer little chance of any positive risk premium relative to bonds or cash, using any reasonable projection of expected cash flows, and 2) are sustained because investors believe they can sell the asset to someone else for a higher price tomorrow, with little regard for the underlying fundamentals
  • Efficient market hypothesis has been stretched to fit observed market behavior, by allowing cross-sectional and intertemporal variations in risk premia
  • Prices adjust until the marginal investor becomes willing to assume both market risk and assorted factor-related risks. In this view, high valuation levels don’t represent mispricing; the risk premia just happen to be sufficiently low as to justify the prices
  • Under certain conditions, investors will raise their estimates of future market returns
  • Investors allow their return expectations to drift from reasonable models of fair valuation, and instead expect future buyers to pay even higher prices for stocks with already sky-high valuations, which, of course, they do – until they don’t – and the market collapses

It’s a bubble because…

  • Over the first quarter of 2018, Tesla has been an excellent example of a micro-bubble
    • Current price is arguably fair if most cars are powered by electricity in 10 years, if most of these cars are made by Tesla, if Tesla can make those cars with sufficient margin and quality control and can service the cars properly, and if Tesla can raise additional capital sufficient to cover a $3 billion annual cash drain and another billion to service its debt
    • This seems an unduly optimistic array of assumptions, especially given the magnitude of Tesla’s debt burden
    • Absent the unfolding of this rosy scenario, Tesla’s current price would require remarkably aggressive assumptions to deliver a positive risk premium
    • Because the current price is acceptable to the marginal buyer and seller, there will always be a cohort that says, “This is no bubble!”
  • Sector and broad market bubbles are much rarer events. A bubble occurs in a sector or a market for which an implausible set of circumstances must prevail in order for the sector or market to collectively deliver a positive risk premium relative to bonds or cash, even though sufficiently aggressive assumptions could realistically occur to justify any single stock’s price
    • 1999-2000 tech, or dot-com, bubble is the poster child for a broad market bubble
    • For the tech sector, to deliver a positive risk premium compared to the 6% bond yield at that time, most tech stocks would have had to produce rapid growth far into the future, even though few could have succeeded unless their fiercest competitors were struggling
    • At the beginning of 2000, the 10 largest market cap tech stocks in the US, collectively representing a 25% share of the S&P 500 did not live up to the excessively optimistic expectations
    • Over the next 18 years, not a single one beat the market
  • Arguments for the future value of cryptocurrencies bring back fond memories of the “price-to-eyeballs” metrics used to justify the market cap of businesses such as Pets.com
    • Nonetheless, price of bitcoin rose by 1,369% in 2017
    • Even if we assume that bitcoin has merit as a libertarian alternative to government-sourced fiat currency, it’s hard to justify today’s 1,500 different cryptocurrencies
    • Bitcoin currently consumes about 0.25% of total global electricity consumption – all just to produce new coins on a nonphysical ledger and move these coins around on electronic exchanges
  • At the end of January 2018, 7 largest-cap stocks in the world were all tech fliers: Alphabet, Apple, Microsoft, Facebook, Amazon, Tencent, and Alibaba
  • History shows that, on average, just two stocks from the global market-cap top 10 list remain on the list a decade later
    • The two survivors almost always include the number one stock. But the number one stock has never been top dog a decade later, ultimately underperforming and moving lower on the list
    • The second surviving stock has 50/50 odds of beating the market
    • If this history repeats, 9 of the top 10 stocks will underperform over the next 10 years, and just one has a 50% chance of underperforming
  • Not only are the market prices of most tech darlings far above reasonable valuation models, investors are overwhelmingly positive and projecting high future returns

So what is an investor to do?

  • A reasonable first step is to sell, or greatly reduce, our holdings of bubble-priced assets
  • 2 most dangerous things about a bubble are that 1) markets can go far beyond any objective valuation measure, and 2) investors can never know with any confidence when the bubble will pop and the market will turn
  • Agency issues may even lead sophisticated investors who identify the bubble to buy in and ride the momentum, propagating bubble behavior in the short run

Conclusion

  • An investor can materially reduce or eliminate their exposure to bubble assets. If we cannot construct a reasonable scenario in which the bubble assets could offer an acceptable risk premium, the “greater fool” rationale- someone will pay more for it later- resembles picking up nickels in front of a steamroller; at a minimum, we can underweight these assets
  • An investor can seek anti-bubbles in the market and invest them. Anti-bubbles are sectors or markets priced at levels that cannot plausibly deliver anything but a large risk premium. Anti-bubble cannot exist in a single asset because almost any asset’s price can drop to zero. But consider junk bonds, financials, and consumer durables in early 2009. Each failure of a single company meant that the survivors in that sector had less competition, higher margins, and a clear runway. Collectively, the sector itself couldn’t fail to deliver a very large risk premium, barring a handful of Armageddon scenarios. Similar to the trajectory of a bubble, an anti-bubble continues to collapse, until it turns. Therefore, averaging into our positions, with an eye toward not exceeding the investor’s tolerance for maverick risk, is a prudent way to invest
  • An investor can diversify into investments that are not in bubble territory. As of early 2018, EM equities and many developed-country stock markets are trading at discounts to their historic valuations rather than the extravagant premium of the S&P 500. If low yields in the US justify high CAPE ratios in the US, then why do zero yields in Europe lead to CAPE ratio of 16x? Other markets offer better places to take on market risk
  • An investor can remember lessons learned from past bubbles, such as the collateral damage done to the technology-led cap-weighted indices. S&P 500 was savaged in the aftermath of the dot-com bubble, down 23.4% over the 24 months from March 2000 to March 2002, on its way to an eventual 49% decline just six months later. While tech stocks were in free fall, the average US stock rose 7.0% over the same two-year period, then suffered a short, sharp 36% bear market. For most stocks, the bull market of the 1990s ended not in 2000 when the tech bubble burst, but in March 2002

Research Affiliates: Yes. It’s a Bubble. So What?, April 2018

Image Source: Research Affiliates, Worldscope

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