How do you profit from market bubbles? Invest in “anti-bubbles”

The only real way to profit from market bubbles is to avoid them and invest in “anti-bubbles” instead. John Stepek explains what an anti-bubble is, and picks some of the most promising.

Few topics obsess investors more than bubbles in markets. The good news is that it's easy to spot bubbles. The bad news is that it's still almost impossible to profit from them.

Rob Arnott, Bradford Cornell and Shane Shepherd at US asset manager Research Affiliates have just put out an interesting paper titled "Bubble, Bubble, Toil and Trouble".

The piece follows an earlier paper they wrote on bubbles last year. In it, they look at how their predictions have fared, and also review the state of the market today.

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So what is a bubble? It has two main characteristics, say the team. One is that "the asset or asset class offers little chance of a positive risk premium relative to bonds or cash, using a generally accepted valuation model with a plausible projection of expected cash flows."

In other words, on any sensible valuation method, the thing looks wildly overvalued.

The second which follows on from the first is that investors don't care. They are buying regardless of valuation because they expect to flog it for more money to some "greater fool" further down the line.

In short, a bubble is where investors pile into clearly overpriced assets because they think they'll get out before the house of cards collapses. Seems a decent definition to me.

So what's in bubble territory today? As far as they're concerned, it's mostly about tech.

They warn that the big US market indices have become extremely top heavy in the FANG (Facebook, Amazon, Netflix, Google/Alphabet) stocks along with other big tech names such as Microsoft.

Note that not all of these individual stocks are bubbles the authors note that to justify the valuations of Apple and Microsoft, you need only make "aggressive" assumptions, rather than implausible ones.

But as a sector, tech is too expensive. And a correction at the end of last year hasn't changed this. The implication is that buying US index trackers is also a mistake as these are heavily exposed to any tech bust.

Similarly, they're not keen on bitcoin, which they liken to the tulip bubble of 1638. So from that point of view, the advice is to avoid those assets.

That's all very well. Avoiding bubbles is one thing, but how do you profit from them?

Well, this is where we come to one of the most fundamental and frustrating problems with bubbles for investors. This is the fact that, "identifying a bubble does not guarantee the bubble will burst (although that outcome is highly likely) nor does it provide any insight into when it may burst."

In other words, bubbles aren't hard to spot, but it's very hard to profit from that fact. If you try to short a bubble asset in anticipation of it popping (it's a slightly different story once it's popped), then unless your timing is perfect (ie, unless you're lucky), then you're going to lose money.

Yet, if you decide that you should instead ride the bubble up, you risk getting sucked into it. Because the problem with irrational asset valuations is that there's no way of telling at which point it's simply "too irrational".

As a result, you risk being the investor who cracks and snaps up bitcoin in December 2017, just as it's hitting a peak.

The “anti-bubbles” to invest in now

OK, so we know how to spot bubbles, but we can't profit from them. That's not much fun, you're thinking. Why am I even telling you all this?

Well, because as Research Affiliates point out, there's an interesting counterpoint to bubbles in the market anti-bubbles.

An anti-bubble is, as the name suggests, the opposite of a bubble. In this case, the asset "requires implausibly pessimistic assumptions in order to fail to deliver a solid risk premium".

In other words, investors are ignoring all sensible valuation models and avoiding a sector or selling out purely on herd sentiment.

So you profit from bubbles by avoiding them and investing in anti-bubbles instead.

Which leads to the question: where are these anti-bubbles right now?

One sector the writers point to is emerging-market value stocks. State-owned enterprises (SOEs) are particularly attractive, they reckon. As a group they trade on high dividend yields, low price/earnings ratios, and low price/book ratios.

As to the objections, "yes, there is a real risk of the state expropriating some of those cash flows, but if these SOEs wish to maintain continued access to the global capital markets, they need to continue to return some of the profit to external shareholders."

It's an interesting take. It's one that would have you buying mostly state-backed Chinese financial and energy stocks. I'm not sure how keen I am on it (I'm not entirely convinced that politicians realise how important property rights are), but I can certainly see the appeal.

And as a side note, on the idea that parts of emerging markets count as an anti-bubble, I have to point out a headline I saw in the FT this morning: "Does investing in emerging markets still make sense?" That's not the sort of headline that you see at the top of a market.

What about in developed markets? Well, interestingly enough, the team at Research Affiliates reckons that the UK is worth a look. "We see turmoil over Brexit potentially creating an anti-bubble opportunity in UK shares."

They point out that the MSCI UK index offers a high dividend yield (more than 4%) and is trading at a 25% discount to the rest of the world. "Brexit would need to destroy quite a bit of value in order to nullify this compelling risk premium."

So buy state-owned enterprises in emerging markets, and buy UK stocks. (Although if Jeremy Corbyn gets into power, you might find that you can do both by investing in UK utilities, which may be a political nuance that the American researchers who wrote this paper haven't quite picked up on, unfortunately).

I'll be looking at this topic in more detail in an issue of MoneyWeek magazine later this month if you haven't already subscribed, buy now to get your first six issues free.

Oh, and if you're interested in this topic, I have a lot more on bubbles and busts and how investors can take advantage of them in my book on contrarian investing, The Sceptical Investor, which you can buy here.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.