By Jack Forehand, CFA (@practicalquant)
The recent rise in stock market interest among retail investors has certainly been apparent among my friends. In normal times, I might get an occasional question about investing, but the number of questions has risen substantially since the market bottom last year.
Some of the questions are either ones that I don’t have an opinion on since I haven’t researched it enough (i.e should I buy Bitcoin?) or ones that have obvious answers (i.e should I buy Gamestop call options?), but I got a question the other day that required a more detailed explanation because the answer to the two different parts of it seem to contradict each other.
The two questions were the following:
- Is the stock market in a bubble?
- If so, what should I do about it?
Since a big part of why I write articles is to try to refine my own thought process, I decided it might be easier to try to answer it here.
So let’s tackle each part individually.
The Varying Definitions of Bubbles
In order to determine whether we are in a bubble, we first need a way to define one. Rather than do that myself, it is probably easier to defer to some people who are smarter than I am and have done the work to look at common characteristics of past bubbles.
Here is how Research Affiliates founder Rob Arnott defined a bubble in a 2018 article.
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.https://www.researchaffiliates.com/en_us/publications/articles/668-yes-its-a-bubble-so-what.html
Cliff Asness of AQR defined it this way.
To have content, the term bubble should indicate a price that no reasonable future outcome can justify. I believe that tech stocks in early 2000 fit this description. I don’t think there were assumptions – short of them owning the GDP of the Earth – that justified their valuations. However, in the wake of 1999-2000 and 2007-2008 and with the prevalence of the use of the word “bubble” to describe these two instances, we have dumbed the world down and now use it too much. An asset or a security is often declared to be in a bubble when it is more accurate to describe it as “expensive” or possessing a “lower than normal expected return.” The descriptions “lower than normal expected return” and “bubble” are not the same thing.https://alphaarchitect.com/2013/12/16/so-what-exactly-is-a-bubble-anyway/
There is a lot we can learn from both of those quotes.
I think the easiest way to look at bubbles is that an asset class is likely in one when it takes unrealistic assumptions to build a case that you will receive a positive return from it over a reasonable time frame. A bubble is also characterized by investors purchasing assets that they don’t understand, with the major reason for their investment being that they expect someone else to buy it from them for a higher price. That is the essence of the Rob Arnott definition.
The Cliff Asness quote is very important as well, though. You will likely see the word bubble used around twenty times for every one time where it is actually appropriate. A bubble doesn’t mean an asset is expensive. It means there is no way to justify its valuation and the eventual outcome is an inevitably bad one.
So are we in a bubble today?
I think it depends on where you look. The overall stock market is clearly expensive by historical standards, but in my opinion, it doesn’t seem to have reached a point where you can’t possibly justify current valuations. Beneath the surface, there are some areas where there is a much stronger case to be made that bubbles exist. For example, some technology stocks are priced at levels that would require their market share to exceed the size of the entire market they operate in. But that likely does not include the FAANG stocks, which are expensive, but likely aren’t close to meeting the requirements for a bubble.
The Investment Strategy Implications of Bubbles
While it certainly can be fun to debate whether the market is in a bubble at any given time, I think that debate largely misses the point. The reason for that gets back to my friend’s second question.
The most important question to ask with bubbles is not whether we are in one at any given time. The question to ask is “Even if I told you that we were, is there a strategy you can pursue to improve your returns relative to a buy and hold approach?”
And I think for most investors the answer to that is no.
To illustrate this, let’s look back at the 2000 dot-com boom (which most experts would agree was an example of a bubble).
If you were a stock market investor in June of 1997 and were looking at the market’s valuation using the CAPE ratio, this is what you would have seen.
Around that time, the CAPE crossed the highest point it had ever reached. If you were someone looking for evidence of a bubble at the time, that might have given you exactly what you needed. But let’s take things a step further and say I took the decision out of your hands and came from the future to tell you that this period would eventually be commonly looked at as a bubble.
What could you have done with that information to modify your investment strategy to profit from it? I guess the obvious answer would have been to just sell everything and wait for the bubble to burst.
But there is a major problem with that approach. Here is the continuation of that chart to add back the period after 1997 that I cut out.
As you can see, once the market crossed the highest valuation it had ever seen, it kept going for a long time. In fact, it produced 20%+ annual returns from that point until the eventual end in March 2000. Although the decision to go to cash in 1997 might have eventually turned out to be a good one, in my experience almost no investor can sit on the sidelines for three years while everyone around them is making 20%+ annual returns and stick with a choice like that.
And even though the 2000 bubble ended at a CAPE of 45, there is no reason it couldn’t have run a lot further. The Japan bubble got closer to a CAPE of 100 before it was done.
The Futility of Timing Bubbles
Trying to figure out whether we are in a bubble at any given time can certainly be an interesting exercise. But when looking at bubbles from a practical standpoint, it is important to understand that whether we are in a bubble isn’t the most important question. The most important question is how an investor can use that information to adjust their investment strategy in order to enhance their long-term returns. And doing that requires not only identifying bubbles, but also timing their end with a reasonable level of accuracy. Since that is nearly impossible to do, for most of us, bubbles are probably more interesting as cocktail party conversation than as something that should impact our investment strategies.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.