If you’re in the investment biz long enough, you’ll inevitably find yourselves searching for profitable ideas when an asset class is experiencing a bubble. The term “bubble” is a heavily overused term in the financial media and among professional investors. Any large price increase over a short time period, such as a 50% gain over a year, prompts a few writers, analysts or professional investors to describe the runup as a bubble. These bearish folks are typically using the term loosely without a nuanced evaluation to determine if prices have simply reflected new highly positive information.
Additionally, how many times have we heard “bubble” used for assets that have experienced long-term, secular bull markets, such as U.S. or Japanese government bonds, when current prices are not experiencing anything like the bubble phenomenon? Then other folks use the term in a variety of ways to describe investor group think, such as “hedge funds are the next investment bubble,” or “there’s currently a bubble in investor complacency.”
I’m specifically interested in those moments in time, which can last months or even years, when price-insensitive buyers become ever more attracted to rapidly rising prices, thus bidding an asset class price way above fair value. It’s a time when pricing is determined by the one-way thinking associated with the “madness of crowds,” rather than the normal, efficient markets “wisdom of crowds” effect. The massive number of performance chasers overwhelms the financial resources of professional investors and traders attempting to push prices back to fair value by shorting and selling the asset class.
Even though the gap between price and fair value grows ever larger, uncertainty about when the market will top and how much further the price will rise creates a situation where the risk-reward of shorting the asset class becomes very unattractive. The arbs, who are usually pushing prices back to fair value, then step away, or perhaps even join the crowd. Other opportunistic professional investors join the crowd by creating new products and/or new firms to exploit the attractive optionality associated with easy money raising and rapidly rising prices.
Bubbles have occurred about once a generation throughout human history, as new investors enter the market with no experience with how bubbles eventually burst. Examples of the large bubbles include the NASDAQ bubble in the late 1990s and the Japanese stock market bubble in the late 1980s. The current bitcoin and cryptocurrency craze has all the attributes of a bubble.
Many Rapid Price Increases Are Not Bubbles
Just because an asset class has a large and rapid price run doesn’t mean it’s mispriced. One or two U.S. industry groups often have a yearly gain of greater than 50%. Most often, prices have increased to reflect unexpected improved future earnings. Also, most bull market tops don’t have a bubble associated with prices. The topping process is more drawn out as the collective wisdom is formed by market players generally using reasonable judgment of future prospects. Prices ultimately collapse when investors sense an emerging bear market or recession.
Eugene Fama, the Nobel-Prize-winning champion of the efficient markets view, believes there is no such thing as bubbles. Bubbles are only known after the fact, when there’s been a large collapse. Careful analysis of large price increases shows that many, perhaps even half, are never followed by a collapse.1 Simple price formulas for defining a bubble, even the approach used by the famous bubble studiers GMO,2,3 are not enough. We need more information. (more…)
The beginning of the year marks the time when chief investment officers, market strategists and other chief prognosticators publish their top investment themes. Barron’s also publishes their much anticipated “round table” issues in mid to late January, which pull together top investors to discuss the state of the markets and where they see investment opportunities.
There are hundreds of firms producing research all the time, most of it free. The big Wall Street firms produce enormous amounts of content, but so do practically all buy-side investment management firms these days. If you’re not careful, combing through research reports for trading and investment ideas can absorb all of the day. There are also the independent firms such as Ned Davis Research, BCA Research and the Leuthold Group, which are very expensive, but provide lots of interesting and useful information for asset class traders.
Common sense suggests that you can’t just read the research, implement the trades suggested and expect to outperform the market. That would be too easy. This is the case even for costly research from the independents, because after all, tens of thousands of professional portfolio managers can afford these services.
For an asset class trader, reading research and market commentary is important, primarily so you understand what everyone else is thinking, become aware of crowded trades and estimate what information is already priced into the markets. Every once in a while, a new piece of information is gleaned or a new way of thinking about an asset class is found. If discovered ahead of most other market participants, this information can be the seed of a new trade.
At any point in time, there are industry thought leaders who seem to have a special knack for investing and trading the markets. When they speak, I pay careful attention because the probability of discovering a new trade idea from them is much higher than reading the everyday, run-of-the-mill content.
Generally, these thought leaders are very experienced, talented and rich. They’re not inhibited by career risk. Their motivations are aligned with us, because being right about an investment theme is the most important goal associated with speaking publically since the prediction is on the record. Contrast this motivation with that of research content providers and newsletter writers, where maximizing readership is the primary goal. (more…)
Liquid alternative funds are the new hip product sold by investment management companies. Liquid alt funds offer strategies that have been used by hedge funds, managed futures funds and private partnerships for many years with the potential to earn a higher risk-adjusted return than stocks and bonds often combined with a low correlation. Previously this space was largely off limits to small investors due to institutional-sized minimums or the need to be an accredited investor. Now these strategies are accessible to all investors via ETF and open-ended fund structures, which offer daily liquidity.
The trend towards liquid alt funds is motivated by the desire for enhanced portfolio diversification and the need to do something about low bond yields. These were the same motivations that led to the massive growth of hedge fund assets over the past 10 years as pension funds allocated to this space following the 2000 to 2002 bear market.
I gravitated to asset classes fairly quickly when I first started trading. I had a 60 hour/week engineering job, and didn’t have the time to perform any kind of individual security analysis or sort through hundreds of individual stock charts each day. There were substantially fewer asset classes to keep track of, and that was manageable for me. This was in the early 1990s before ETFs were available, so I used individual mutual funds.
Most practitioners in the field define asset classes very broadly, such as stocks, bonds and cash. From these broad asset classes, there are sub-asset categories among stocks and bonds. For instance, Ned Davis Research1 divides the U.S. stock market into nine stock sectors and about a 100 industry groups. Morningstar splits stocks into nine style boxes with growth versus value on one axis, and small versus large capitalization stocks on the other. (more…)