Don’t buy the bubbles

They're relatively easy to spot but that doesn't make it easier to invest wisely. Buy the anti-bubbles instead.

Quantitative easing has given rise to a golden age for bubble-spotting in markets. But what exactly is a bubble, and what can you do about it? A new paper by Rob Arnott, Shane Shepherd and Bradford Cornell from Research Affiliates defines a bubble simply as any situation where investors buy an asset that is highly overvalued on "any reasonable projection of future cash flows" because they believe they will be able to sell it for a higher price in the future (the "greater fool" theory).

Dotcom was a sector-wide bubble, for example; Tesla is a micro-bubble (its current price is only justifiable, say the researchers, if you believe that most cars will be electrically powered within a decade, and that Tesla will make the majority of them); and today, tech giants the so-called FANGs such as Facebook, Apple, Netflix and Google, look bubbly, too.

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But what should you do about it? The trouble with bubbles is that, while they're not necessarily as hard to spot as some people make out, calling the turning point is nearly impossible. The good news is that this is one area where being an individual investor gives you an advantage. It's hard for fund managers to avoid bubbles, because if they don't take part, they tend to underperform. Do that for too long, and their clients will fire them. For a career based on collecting as many assets as possible so as to harvest fees from those assets, that can be lethal.

That's not a problem for an individual. The only person you have to answer to is yourself (which admittedly, can also be a struggle). So rather than worry about timing a bubble trade, you should look for "anti-bubbles" to invest in. These "are sectors or markets priced at levels that cannot plausibly deliver anything but a large risk premium".

In other words, buy cheap assets that have either been neglected as a result of an existing bubble, or once they have been decimated in a post-bubble crash. "An anti-bubble can be a rich source of profit for the patient investor." Do however, buy into the sector as a whole, rather than one specific company for example, while the entire "financials" sector cannot go bust (except in almost unthinkably extreme circumstances), any given bank certainly could.

Secondly, if you're struggling to find "anti-bubbles", then the other solution is to diversify into areas that aren't in bubble territory. For example, argues Research Affiliates, several stockmarkets currently trade below their historic valuations, rather than well above them (the UK, for example, does not look overly dear). Also, "value stocks are trading at quite attractive levels". In short, it's simple if you don't want to get swept away by a bubble, avoid what's expensive and buy what's cheap.

I wish I knew what the Cape ratio was, but I'm too embarrassed to ask

Investors often use the price/earnings (p/e) ratio to judge whether a stock is cheap or not. It's a simple measure to calculate (hence its popularity) you simply divide the share price by earnings per share. A low number (below ten, say) suggests that you aren't paying much for each given £1 of earnings, while a high number indicates a stock may be expensive (or growing rapidly).

However, the basic p/e is highly flawed. Using just one year of profits means a stock particularly one in a cyclical business, such as mining can look cheap because profits happen to be peaking at that point, and are set to plunge when business turns back down in line with the economic cycle. So in the 1930s, value investors Benjamin Graham and David Dodd suggested that analysts should instead take the average of earnings for the previous five to ten years. This smooths out the data, minimising the impact of economic cycles.

John Young Campbell of Princeton and Robert Shiller of Yale University revived Graham and Dodd's suggestion in a 1988 paper. This suggested that the ratio of prices to ten-year average earnings was strongly correlated with returns over the next 20 years. Shiller promoted the idea of a ten-year cyclically adjusted p/e ratio (aka Cape) in his book Irrational Exuberance, and hence it is sometimes known as the Shiller Cape.

Some of the Cape's most notable successes have included indicating that the US stockmarket was extremely expensive ahead of the tech-bubble crash in the late 1990s, and also that it was unusually cheap after the 2008-09 financial crisis, even though the raw p/e was above 100. The Cape has been shown to work with other global markets, too.

Currently the US market is particularly expensive compared with its long-term average on a Cape basis and has been for some time although in 1999 the S&P was even more overvalued than it is today.