How to invest in anti-bubbles

The good news about bubbles is that they’re easy to spot. The bad news is that they’re hard to profit from.

Few investment topics garner as many headlines as market bubbles, and little wonder. They represent an opportunity to make a lot of money or a chance to rail against the irrationality of the herd. But how do you spot a bubble, and how can you profit from it? A new paper from Rob Arnott, Bradford Cornell and Shane Shepherd at US asset manager Research Affiliates, titled "Bubble, Bubble, Toil and Trouble", provides useful answers to both of those questions.

The good news is that a bubble is pretty easy to spot. It has two main characteristics. Firstly, "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". Secondly, investors don't care about this. They buy regardless of how ridiculous the valuation is, because they expect to sell at a profit to a "greater fool" further down the line. In short, bubbles happen when investors pile into clearly overpriced assets in the hope they'll keep rising.

So what looks bubbly today? The team highlights US tech stocks (the FANGs specifically), and US market trackers (top-heavy in such stocks) in general. They're also sceptical about cryptocurrency bitcoin, likening it to the tulip bubble of the 1630s. Of course, it's one thing to identify a bubble, but profiting directly from it is a lot harder. The risk with buying in is that it might be the top. The risk with short-selling (betting on a fall) is that it might go on for a lot longer. Either way, you lose.

So the best option, according to Arnott and his team, is to ignore bubbles altogether and instead invest in "anti-bubbles". These are the assets that are neglected while everyone is paying attention to the superstars, and so become so cheap that it takes "implausibly pessimistic assumptions in order to fail to deliver a solid risk premium". So where are these hated anti-bubble assets today?

Emerging-market value stocks and state-owned enterprises (SOEs) in particular look cheap, they reckon. The majority (two-thirds of the top 50) are in China, with half of those in the financial sector. There's no specific SOE index, but you could get exposure to many of the stocks with a China exchange-traded fund (ETF). One option to explore on this front could be the CSOP Source FTSE China A50 ETF (LSE: CHNA), which tracks the 50 largest companies listed on the Shanghai and Shezhen stock exchanges. More than 50% of the ETF is in financial stocks. As for developed markets well, you might be able to guess their favoured option. "We see turmoil over Brexit potentially creating an anti-bubble opportunity in UK shares." See page 4 for more.

I wish I knew what a yield curve was, but I'm too embarrassed to ask

Bonds are IOUs. You lend the issuer money for a set period, in exchange for a regular interest payment (coupon), and get your money back when the bond "matures". Once issued, bonds trade on the open market, which means the price can rise or fall depending on the appeal of the coupon, and the issuer's creditworthiness. The coupon as a percentage of the bond's price gives you the simple yield.

The yield curve compares the yield on bonds of the same credit quality, but different maturities (so the Treasury yield curve charts the yields on everything from three-month US government debt to the 30-year Treasury). The curve normally slopes up from left to right, because longer-dated bonds typically yield more than shorter-term ones. That's because money today is usually worth more than money in a year's time. For taking the risk of waiting for longer to be repaid, investors want more interest.

If the yield curve starts to flatten in other words, the gap (or "spread") between yields on short-term bonds and long-term ones narrows then it suggests that investors believe inflation will fall (and so don't need as high a yield from longer-term bonds); or that short-term interest rates will rise (driving up the yield on shorter-term bonds); or both.

Eventually, a flat yield curve may give way to an inverted one. This suggests that investors expect interest rates in the future to be lower than today, meaning they are happy to lock in today's yields on longer-term bonds, because they expect them to be even lower tomorrow. That in turn suggests they expect the economy to slow down, forcing the central bank to cut rates in hope of boosting demand and getting growth going again. In recent months, the yield curve between the three-month US government debt and the ten-year has inverted. But the spread between the two-year and the ten-year (often seen as a more definitive recession signal) has remained positive.

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