The market is looking bubbly – here's the best defence for investors right now

We've been living through a stockmarket bubble built on low interest rates and tech monopolies. But the trend could be about to turn, says John Stepek. Here’s how to protect yourself.

An investment bubble is a tricky thing to spot. Academic definitions are useful from a historic point of view, but they're not great for identifying bubbles in real time. However, some of the more reliable indicators are starting to look pretty promising.

One of the tell-tale signs that markets are getting bubbly is when companies start to join in the fun, in the form of growing M&A (merger and acquisition) and IPO (initial public offering) activity. Chief executives start having the instinct to expand and empire build, aided and abetted by investment bankers, hungry for fee income. As a result, we get lots of merger and acquisition activity.

Companies are feeling exuberant again

After a bit of a dull period, that's really starting to explode higher now. Shareholders in Codemasters are enjoying a rather exciting bidding war over the computer games company. The UK video-game maker is now being fought over by Electronic Arts and Take-Two Interactive, two of the biggest names in the sector. Take Two had offered nearly $1bn. EA have offered $1.2bn. If you're about the same age as me, you might remember Codemasters best from the mid-1980s as a company headed by a couple of teenagers sitting in their bedroom making computer games about an adventurous egg. That's a pretty impressive outcome. 

That said, it's a tiny deal relative to some of the others kicking about. We've also got AstraZeneca buying US biotech Alexion for $39bn. Meanwhile a couple of regional banks in the US – Huntington and TCF – have decided to merge in a deal worth $22bn. As The Market Ear points out, "it looks that all stars are aligned for 'mega merger mania'". As a result, the second half of 2020, it appears, "has a decent chance to be the strongest M&A period in over ten years". This makes sense. A bubble reflects optimism. It also reflects corporations striking while the iron is hot.

Meanwhile, we've just seen some massive market debuts in the form of IPOs from Airbnb and DoorDash. Airbnb allows individuals to advertise their properties for short-term holiday stays. In effect, it's competing with the hotel industry while side-stepping much of the regulation that commercial hotel operators have to comply with. As with most big tech plays, it's as much about regulatory arbitrage as innovative software. 

Airbnb makes no money. It loses money. But when it listed last week, reports the FT's Due Diligence email, its shares shot up to the point where it is now worth twice as much as Marriott, the biggest hotel chain in the world. To be clear, Airbnb has struggled with Covid-19 too, so this isn't about some miraculous immunity to disruption. It's just about enthusiasm for tech stocks.

DoorDash, meanwhile, is just another takeaway delivery firm, like Deliveroo. I struggle to see how a company whose moat consists of bicycles and a software app (in other words, it's more puddle than moat) can be worth very much at all. And yet its shares nearly doubled on its first day of trading last week.

We've been living through a bubble built on low interest rates and tech monopolies. So it makes sense that right as the conditions are ripening for that trend to turn, we're also going to see the biggest and boldest manifestations of that trend. AirBnB is a pretty good example – a tech disruptor, making its money by "digitising" the most solid asset of them all – property. DoorDash is even better – a company that makes no money and has no competitive edge, seeing investors knocking down the doors to get it.

Meanwhile, Facebook is being threatened with a break-up. You can already see the pins that will pop this bubble. But it has to grow big enough for them to make contact.

The best way to invest in an end-stage bubble

How does this all end? It usually ends in tears – for those who buy the bubble asset at the wrong point – and I doubt this time will be any different. However, the more important point to remember is that you don't know when it will end. So don't try to short the bubble. That's a near-certain way to lose money.

Does that mean you can't profit from bubbles? Not at all. You just need to find a way to play them that doesn't involve timing the market. The best way to do that is to invest in the “anti-bubble” assets that have been neglected amid all the excitement about the hottest stocks. You buy them, and then sit on them. When the bubble bursts, they are in the best position to cope with the fallout and to recover the quickest.

What are the anti-bubble assets right now?

US value fund manager GMO just released a report pointing out that value stocks suffered their worst 12-month period on record in the year to 30 September, relative to the wider market. “Value” is of course quite a subjective term – it really just means “cheap”, but there are many ways to measure cheapness.

However, as the report’s authors, Ben Inker and John Pease, point out, it really doesn't matter how you define cheap – value stocks are dirt cheap on almost every single measure you can imagine. The only point in history that really bears comparison as being any more extreme is the tech bubble of 2000 – and that really was an extreme.

They also find that this doesn't just relate to the US – value stocks everywhere are inexpensive relative to their home markets. Meanwhile, as a corollary, growth stocks are very expensive. In fact, on a price/sales ratio basis, growth stocks are now even more expensive than they were in 2000, which takes quite some doing.

Long story short, we probably are in a bubble market. But the good news is that there's a simple solution that doesn't require you to turn into a short-selling genius – and that's to buy cheap stuff.

What cheap stuff? We've been looking at all of this in more detail in recent issues of MoneyWeek magazine and we'll be continuing to do so all through 2021. So if you want to get your portfolio off to the best start for the New Year, I suggest you subscribe now. Get your first six issues free here.

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