Market commentators often call a period of higher valuations a market bubble. We hear less discussion of what a bubble really is, how to handle one, and how to make money from it.

This is because it’s a difficult task, requiring the right timing and the right mindset.

Still, it can be done.

Is It a Bubble?

What defines a market bubble is a matter of contention, but most definitions focus on a disconnect between economic fundamentals and market prices. This can be record high P/E ratios or valuation metrics like the Buffett Indicator: the Market capitalization-to-GDP ratio.

A joke on “bubble spotters” is that there have predicted 23 out of the last 4 bubbles. The joke is that, more often than not, when people claim to have spotted a bubble, we are (very) far from the top of the market.

For the same reason, most of the people making claims about bubbles are often criticized as “perma-bear”, as in being permanently “bearish”, and having negative expectations.

Even legendary investors like Michael Burry (see invetor profile) have almost gone bankrupt betting against actual bubbles. As the saying goes “The markets can remain irrational longer than you can remain solvent“.

Besides, investors mostly make money when markets go up. So sitting it out because “it’s a bubble” is a sure way to lose money and underperform other investors.

“Far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.”
Peter Lynch – One Up on Wall Street

So the question is not so much “is it a bubble”. This is only something you can be sure of in hindsight.

It is more “how can I still invest while staying protected if it pops”. (I will discuss the question of actively betting against a bubble later).

Bubble Protections

We will discuss in the next chapters how to ride a bubble on the way up. But first, you should know how to limit the potential damages from it.

The first thing is to realize it is rarely possible to time the top of a bubble accurately, other than by sheer luck. For this reason, using a few protections is recommended when stock valuations are starting to look stretched.

The first protection method is stop loss orders. This is an order that is given to a broker requiring him to sell a stock if it falls below a given price. This way, the losses will be automatically limited to a certain percentage in case of a sudden crash. This is especially useful for buy-and-hold investors, who might not follow news or price movements on a daily basis.

Another method is to cash in some of the gains already made. This lets you recover your initial investment or even gain a profit if markets turn down.

Lastly, you can take a more cautious approach as the stock market or a sector reaches points where the price appears to be outrunning value. Most investors get caught up in extrapolating short-term trends to an infinite timeline. Instead, you can turn to more defensive holdings, sell what might be now overvalued, and maybe increase the percentage of cash in your portfolio.

The Momentum Method

Momentum trading is both a popular and profitable way to trade markets. The idea is simple “buy what goes up, sell what goes down”. Of course, the detailed method could be worth an entire article. Still, it does make sense, as the direction of markets and individual stocks tend to be one-sided for long periods of time, often years.

This is the reason stocks like Tesla’s can go from slightly expensive, to highly expensive to insanely expensive (as measured by P/E, price to free cash flow or other traditional valuation metrics). Rising prices take a life of their own and create more rise.

Another explanation for this phenomenon is reflexivity, a concept popularised by George Soros, a form of self-fulfilling prophecy.

To take the Tesla example, rising share prices allowed the company to raise more money, allowing it to grow faster, and causing the stock to rise even more. Rinse and repeat.

So the first way to invest or trade a bubble is to go with the flow. Or at the very least, not fight against the dominant current. Knowing when the trend is broken and it’s time to sell is another story.

The Behavioural Method

Bubbles are first and foremost a psychological phenomenon. They occur when most of the market participants convince themselves that “this time is different”.

This is why pessimists can easily spot real (and imagined) bubbles. They never believe good times are ahead. But being pessimists, they dismiss genuine good news. And they also often grossly underestimate the enthusiasm of the other, more numerous, investors.

For example, when Covid arrive in the US, we experienced the very brutal and short-lived bear market of 2020. But while dramatic, covid and lockdowns did not break the spirit of the crowd of investors. So as soon as the government promptly pushed stimulus measures, the markets rose again to all-time highs. (see arrows below).

Shopify stock performance 2017 - 2022 — Shopify stock price (Yahoo Finance)

The second arrow in the graph was when optimism for e-commerce (a sector of which Shopify is a leader) was completely unrestrained. The pandemic was supposed to have permanently changed the way we work and shop. Physical shops were obsolete. Amazon and Shopify were not only the future of retail but the ONLY future.

This was a sign things had gone too far. Record online sales had to slump soon with lockdowns going away and people spending their money again traveling, going to restaurants, concerts, etc…

In that context, a price-to-sales ratio of 44 was pricing way too much immediate growth. This bubble popped, and the stock has since then lost 70-80% of its value.

The behavioral method could have spotted the general area that would turn out to be the top of the bubble, not by analyzing financial ratios but by looking at the “peak optimism” sentiment.

By 2021, many well-established and old-fashioned value funds had closed, and the SPAC boom as well as crypto was out of control. Generally, investors in tech stocks were at a level of optimism not seen since 1999 during the dot-com bubble. This meant the mood had only one possible direction to go: down (and so did the share prices).

The Taxi Driver Warning

Another behavioral indicator is the so-called “barbershop theory” (or shoeshiner theory or taxi driver theory). This is the idea that when someone as far as possible from a finance specialist, like a barber or a taxi driver, starts to discuss stock tips, the end of the bubble is near.

This is because “normal” people normally don’t know much about the stock market or new and technical investments like crypto. This is due to three phenomena:

Non-finance professionals pay attention to an asset class only after very large gains already occurred.
When even they are fully invested, there is no one left to inject more money into the bubble.
Professional investors are probably already heading for the exit, leaving the non-professionals “holding the bag”.

When people with no specific knowledge start to get enthusiastic, that’s a sign that the bubble is approaching its peak.

Behavioral Investing Limits

It’s easy to describe behavioral methods but difficult to execute them.

There is a fine balance between being a contrarian (disagreeing with the crowd) and daring enough to invest all the way up.

The ability to simultaneously invest in a bubble but not get too fearful or optimistic on the way to the top is a rare skill indeed.

Betting Against a Bubble

Momentum and behavioral methods, or both, are a way to ride the bubble and try to survive its popping.

You can alternatively try to short a bubble. This can be done by naked shorts or put options. Both are highly risky methods.

Remember, even an excellent, full-time investor like Michael Burry almost destroyed his career doing it, as illustrated in the book and movie “The Big Short“. Cohorts of investors ruined themselves betting against Tesla all the way up to a trillion-dollar valuation (including the notorious TeslaQ group).

Even if a stock is clearly overvalued, shorting is risky. To short a stock effectively you have to not only predict that it will fall but predict when it will fall. Again, the market can stay irrational longer than you can stay solvent.

So this is something for the most risk-tolerant investors, and only with plenty of experience. I would also suspect it is best mixed with some elements of the momentum and behavioral methods. It is better to start shorting only once the collective mood has soured or significant losses have happened. Ideally both.

One last possibility is hedging. This word covers a large set of methods to compensate for volatility. This too could be an entire article. Due to its inherent complexity, this is a solution best left to experienced investors.

Conclusion

Bubbles are among the most-discussed financial phenomena. The fortunes made or lost in them are fascinating. I also think they are discussed way too much.

Most of the talk about a bubble is at best wasted time, at most misleading. A real bubble occurs only once a decade on average. As Lynch said, investors who worry about bubbles will most likely miss most bull markets and the profits that go with them.

This is not to say that signs of a bubble should always be ignored. What goes up will go down. When a situation is absolutely unsustainable, and the consensus is “this time is different”, it might be time to take the most profit and look for greener pastures.

For example, in mid-2021, everybody had given up on tech stock ever getting cheaper. They had also given up on recovery for energy stocks. Being contrarian did not require risky short selling. A progressive rotation from a favored to an unpopular sector could have done the trick.

As always, good margins of safety and diversification will help manage the risks of a bubble. Remember, investing is more akin to a marathon than a sprint.

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This article originally appeared on FinMasters.com: Spotting and Investing (or Trading) in a Market Bubble

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