Navigating Asset Bubbles for Profits

Large price runups, such as a gain of 100% over two years, are rare.1 In a previous blog post, I presented 10 attributes to distinguish asset class bubbles from large price runups that are justified by improving fundamentals. Those bubble attributes are:

  1. Heavy retail investor involvement
  2. New-era thinking
  3. Irrational valuations
  4. Five or more years of swiftly rising prices
  5. Parabolic rise in price
  6. Shorting is unattractive or impossible
  7. Social mania
  8. Product providers exploit excessive demand
  9. Leverage fuels more buying
  10. Bubbles are late-cycle phenomena

As asset class traders, we are especially interested in bubbles as a potential huge source of alpha when they collapse. As it turns out, bubbles are a lot tougher to exploit than it might seem. In this blog post, we’ll delve into bubble characteristics in more detail, and then investigate the best ways to trade asset classes that are experiencing a bubble.

We’ll examine bubble characteristics over the short term (plus and minus three years around the peak) and then longer term (a decade or more). When doing this sort of analysis, we need to at least acknowledge that various forms of hindsight bias can creep into such work since we are examining known price runups that ultimately crashed spectacularly.

It’s possible that we should include a few historical parabolic runups that did not ultimately pop.1 I’m hopeful that the lack of bubble attributes associated with these moves provides the justification for eliminating these from consideration, but I’m not completely sure. I may have also declared a few large up and down moves as bubbles (for instance, Chinese equities in 2007), when perhaps this price move had no more bubble attributes than a big move that ultimately didn’t end in a long period of underperformance (for example, the 1987 crash). (more…)

Long-Term Relative Strength Line Trend Changes

Often in trading we become totally engrossed in searching for short-term opportunities with a hyper-focus on news flow and daily price movements. Occasionally it’s good to drastically alter time frames, especially if your creativity has dried up on short-term ideas. One way to search for new trades is to scan asset classes that have performed the worst over the previous decade. This is especially interesting when there’s been a large divergence of performance in asset class returns over the previous 5 to 10 years.

Table 1 shows a ranking of the worst-performing ETFs by 10-year annualized returns as of October 31, 2017. When tabulating this ranking, I excluded the ProShares daily leveraging funds and commodity exchange traded notes. For comparison, the S&P 500 returned 7.51% per year during this time frame. This list contains many ETFs in the energy space, with a few niche asset classes (clean energy, gold miners, steel and nuclear), country funds (Russia, Italy and Brazil) and two currencies (British pound and Canadian dollar).

Table 1: Worst-performing U.S. ETFs based on 10-year annualized returns, as of October 31, 2017. (Note: S&P 500 return over same period was 7.51%/year). Source is Morningstar.

Often these asset classes were popular many years ago, but as the terrible performance persisted over a decade’s time, more and more traders and portfolio managers shifted their focus to better-performing asset classes. With a niche asset class, such as gold mining or solar energy stocks, the last remaining holders are the enthusiasts (gold bugs), index funds and retail investors owning such a small position that to them it’s easier to ignore rather than take a loss on a sale. (more…)