Let me be clear: Stocks, even go-go technology stocks, aren’t in a bubble. But there are increasing signs of euphoria, and it is plausible that a true blowout end to the bull market could be on the way soon. If a bubble is finally developing, investors will have a chance to make a ton of cash, to lose it again, or to miss out entirely. How best to play a euphoric market?
Start with the signs of frothy behavior. For years stocks have been going up without wild exuberance. Investors have felt compelled to buy shares because bond yields are so low, but this deliberate engineering of a bull market by the central banks didn’t engender excitement. The narrative of the market was one of caution. Investors for a long time bought the safest stocks they could, pressed chief executives to return cash rather than boost capital spending, avoided big glitzy takeovers and worried — wow how they worried! — about a repeat of the 2008 financial crisis.
Ten years on from Lehman Brothers’ failure that worry is finally dissipating. The market’s story line has changed to one of disruptive, low-inflation growth, fueled by easy money.
Shareholders are cheering on corporate capex and less excited about buybacks, as they bet on a synchronized global economic boom. There are few fears of financial excess, even as some of the precrisis financing tricks make a comeback.
So far, so bullish. What marks out a bubble is people buying things they know are overpriced in the hope of selling them on at even higher markups to a greater fool. We aren’t there yet, bitcoin-related stocks aside, but as the euphoria grows, this becomes ever more likely — with the tech sector the most likely beneficiary.
The first few days of 2018 certainly point toward high spirits in the tech sector. The FANG stocks of Facebook Inc. (FB), Amazon.com Inc. (AMZN), Netflix Inc. (NFLX) and Google parent Alphabet Inc. (GOOG) all rose more than 5% last week, double the wider market’s gains, as last year’s tech run continued. The U.S. tech giants and their Chinese counterparts are leading a boom in large companies with scope for fast earnings growth.
Sentiment measures suggest the enthusiasm is more broadly shared. The far-from-scientific American Association of Individual Investors survey of its members shows the most bulls and the least bears since the end of 2010. Investors Intelligence’s survey of financial newsletters is even more positive, with the highest number of bulls since the start of 1987. Investment bank surveys say record or near-record proportions of fund managers are holding more risky portfolios than usual.
Derivatives tell the same story of fading fears. The 10-day average ratio of equity-put options (which protect against price falls) to calls (which gain from price rises) is the lowest in four years, and has tumbled from the postcrisis high reached amid the China concerns of early 2016.
It is too soon to call this a bubble. U.S. equities are among the most expensive they have ever been on many measures, with the median stock matching valuations that were reached during the dot-com peak. With interest rates and bond yields still depressed, a case can be made that this merely points to low returns ahead, not an effervescent market.
Jeremy Grantham, co-founder of Boston fund manager Grantham, Mayo, Van Otterloo & Co, says he sees early signs of the “touchy-feely” measures of excess that go with a bubble, such as media focus on a clutch of fashionable stocks. He thinks a meltup of the S&P 500 (.SPX) to between 3400 and 3700 in the next year or two is more likely than not.
The prospect of gains of 24% to 35% sounds easy to trade. Just buy! Even better, buy the big tech stocks that should go up by a multiple of those in a true bubble (from the start of 1999 to the dot-com peak in March 2000 U.S. tech stocks more than doubled).
The problem is timing the exit. The tech sector lost 80% when the tech bubble popped, as investors scrambled to dump shares at any price. Those who held from mid-1996 on gave back all their bubble gains by October 2002. That leaves four options:
- Get out early. As the bubble builds, sell into strength. You will feel increasingly stupid while the bubble builds, so only do this if you can resist the fear of missing out.
- Get out late. Buy into the bubble, but be ready to sell quick after it pops. Timing is tough, as there is no way to be sure if even a big drop is the end or just a pause, as with the 20% tech drops in 1997 and 1998 and the 10% fall in 1999. It is easy to sell too early thinking the bubble is done.
- Stay in, stay cautious. Buy high-quality companies less affected by tech enthusiasm, or cheap value stocks shunned by those chasing growth, perhaps with a bit of tech to share in bubble gains. Unfortunately, quality stocks are already expensive, and value stocks could easily fall a lot more before they come back into fashion.
- Look elsewhere. Mr. Grantham favors loading up on emerging-market stocks, which are cheaper. They probably would be hit in the short run by a U.S. bubble popping, however.
If a bubble develops, pick a strategy and don’t get greedy: Always think of what will be left after it bursts. For the long-term investor bubbles are about survival, because most of those who get rich quick on the way up get poor quick again on the way back down.
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