Strategies to Stay Ahead in a Market Bubble

U.S. stock markets are already up in 2021, with the S&P 500 having gained 2.55{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9} year to date while the Nasdaq Composite Index is up 4.51{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9}. These gains follow an impressive bull run in 2020, during which the stock market as a whole shook off both the Covid-19 pandemic and the economic recession to add 20{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9} to the Wilshire Total Market Cap, which is a market capitalization-weighted index of the market value of all American stocks actively traded in the U.S.

These high valuations are currently being supported by a number of factors, most notably the easy monetary policy implemented by the Federal Reserve and the expectation that companies will quickly recover from the pandemic to post better results than ever.

According to the “Buffett Indicator,” which compares total market cap to gross domestic product to get an idea of overall stock market valuation, the U.S. market is significantly overvalued at 193{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9}, resulting in an expected return of -2.9{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9} per year in the future, including dividends. Even when we add the assets that the Fed has poured into the markets to the GDP, we get a ratio of 143.2{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9} for an expected annual return of -1.2{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9}.

Are we in a market bubble?

According to a recent survey from E-Trade Financial, only 9{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9} of millionaires do not think we are near a market bubble, while 16{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9} think we are fully in a bubble, 46{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9} thing we’re in somewhat of a bubble and 29{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9} think the market is approaching a bubble. Given this “all show, no substance” market picture, this comes as no surprise.

According to GuruFocus Insider Trends, the ratio of buying and selling among company insiders has also been trending lower in recent months, indicating top executives and others who are closely involved in the business world have been doing more selling than buying. When there is an increase in insider buying, it can often indicate a good time to buy, and the opposite often holds true as well. When insider buying declines and insider selling increases, it can be a sign they are preparing for a fall in stock prices.

One other classic indicator of a market bubble we have been seeing recently is a high number of companies going public. In total, 2020 saw approximately 1,591 listings for a total consideration $331.47 billion, up 42{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9} compared to 2019. The market heated up even more in the U.S. with 480 initial public offerings, representing a new all-time record and a 106{46dd52bca0123ad67b2d1222819e83fd0a56e45ca5068239f05f0c514f1e20f9} increase compared to 2019. The IPO market is expected to see another record-breaking year in 2021 as companies seek to take advantage of favorable investor sentiment to achieve a higher selling price. The last time we saw a wave of IPOs this big was during the dot-com bubble.

With a market bubble likely at hand, many investors are wondering how they can prepare for an eventual crash, and if now is the time to sell. History has shown that bull markets never last forever, and while easy monetary policy can boost stocks in the long run, it feeds into the full “boom and bust” cycle, not just the “boom” portion. Investors make money by buying low and selling high, so the logical conclusion may seem to be selling near the top and then waiting for the bubble to burst.

However, according to famous value and growth investors alike, the answer to the question of how best to stay ahead as a market bubble looms is not to sell. In fact, even the father of value investing, Benjamin Graham, recommended staying invested.

The case for staying invested

Trying to time the market is a gamble at best and counterproductive at worst. Overall, it is an exercise in futility since there are far too many factors affecting the macroeconomic environment than can possibly be taken into account.

In his commentary on Chapter 5 of the fourth revised edition of Benjamin Graham’s “The Intelligent Investor,” Jason Zweig summarized Graham’s case for taking a more passive stance to investing as follows:

“As the financial markets heave and crash their way up and down day after day, the defensive investor can take control of the chaos. Your very refusal to be active, your renunciation of any pretended ability to predict the future, can become your most powerful weapons. By putting every investment decision on autopilot, you drop any self-delusion that you know where stocks are headed, and you take away the market’s power to upset you no matter how bizarrely it bounces.”

For example, if you were worried that the market was overvalued at the end of 2019 and decided to sell your holdings then or in early 2020, you might have avoided the initial market crash in February, but if you then proceeded to wait too long to pick up stocks at the bottom, you might have easily missed out in the long run as the S&P 500 had completely recouped its losses by mid-August. Even if you did manage to buy at the bottom, it would have been due to luck, not skill; the Covid-19 pandemic is a “Black Swan” event, an unexpected factor than any analysis before the end of February failed to fully take into account.

One of the main keys to successful long-term investing is holding on through the ups and downs. If both the company and thus its stock price are expected to improve in the long term, trying to play the ups and downs is inefficient and carries the risk of turning a profitable holding into an unprofitable one. In the long run, the stock market is a weighing machine, and those who stick around for the actual weighing have a higher chance of benefitting.

Lower risk profile

Both bull markets and market bubbles are classified by a surge in risk, whether it be in the form of new and unproven stocks, high-debt growth ventures or overvaluation. When the market appears to be expecting the end of a bubble, it stands to reason that the highest-risk companies are the ones most likely to see their stock prices plummet.

In a GuruFocus Q&A session with Ariel Investments’ Chief Investment Officer Rupal Bhansali, one rader asked, “You have said FAANG stocks are extremely risky. What factors lead you to reach that conclusion?” Bhansali replied:

“Whenever a set of companies have achieved spectacular success as the FAANGS have done, there is a tendency for investors to extrapolate that success into the future and pay up for it. This is a risky set up as good news is priced in, but bad news is not. Investors are not getting paid for risks because they are mistakenly assuming no risks exist.”

Bhansali’s answer gets straight to the point of why high-risk stances are not a good strategy during a market bubble. Market euphoria has failed to take into account the downside, whereas stocks that investors are already pricing in a downside for stand to lose less.

That’s not to say investors should rush off to sell their big tech stocks due to overvaluation. If you still believe in your investment thesis for the company, and that the trend still has a good long-term outlook even if the price does have a chance of taking a sharp hit in the future, then it is still likely best to remain invested. The thing to avoid here is buying at sky-high valuations. If your investing thesis holds true, remaining invested in the stock through the ups and downs of the markets is almost certain to give you a better entry point in the future.

Instead of channeling investment dollars into overvalued stocks or risky new players who are still burning cash, cautious investors may want to turn their attention to more undervalued or defensive areas of the markets in search of places to allocate capital. For example, the utilities sector is known for strong moats, secure dividends and relatively little price fluctuation. Companies with stronger balance sheets also tend to have less downside potential than financially unstable counterparts who rely on bull market funding to keep the lights on.

Have a wish list

It can be difficult to identify good buying opportunities when they come up. Oftentimes, when the markets enter a bear run, investors are left with the conundrum of trying to do ground-up research on new opportunities while the clock keeps ticking. There’s only so much time in the day, and it is all too common to put off deeper research on an attractive name simply because it is too overvalued to purchase at the time, or because it is facing a short-term risk and you are waiting to see the outcome before doing the major legwork, or simply because you do not have the capital to invest in every company you like.

A good way to avoid this issue is to make a wish list (also called a watch list) of stocks that you would like to own if the price were more favorable. Doing deeper research on your wish list and then regularly checking in with the names on it can help you stay on top of your game, resulting in greater mobility to answer the door when opportunity comes knocking.

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