Bubble, Bubble, Toil and Trouble

Key Points

  • The authors define a bubble and an anti-bubble so that investors can avoid or select, respectively—in real time—the impacted assets or asset classes.
  • Today, Tesla, bitcoin, and certain US technology stocks are valued far above their fundamentals and are well into bubble territory. These assets are well avoided by investors, as are US market cap–weighted indices, which have an historically large concentration of pricey and overvalued large-cap tech stocks.
  • Investors who take advantage of today’s anti-bubbles have the opportunity to add value by investing in the emerging markets, particularly state-owned enterprises (SOEs), and by averaging into the UK stock market where stocks are feeling the pressure of Brexit-related uncertainty.
  • Value-oriented smart beta strategies in both the developed and emerging markets offer investors promising investing opportunities outside the many bubbles in today’s global markets.

In April 2018, we published our most-downloaded article ever, “Yes. It’s a Bubble. So What?” Our key purpose was not to make the observation that “Yes, it’s a bubble,” but to offer a formal definition of bubble, which is perhaps the first formal definition that can be used to identify a bubble in real time instead of years after the fact. A second point we made was that bubble prices (asset prices far higher than those a valuation model can justify with plausible assumptions) can continue to soar higher and longer than many of us might imagine. As the saying goes, “the market can remain irrational far longer than you can remain solvent.”1 Indeed, in true bubbles, we should expect them to soar—until they don’t. Our third point was to illustrate how investors can use the definition to identify and avoid the trap of current bubbles and instead seek out anti-bubbles and assets that are likely undervalued.

With the blessings of an admittedly short year of hindsight, how useful were our observations? Most turned out to be spot-on. So where do we see bubbles today, and what should investors do? As Harry Markowitz has observed, “the only free lunches in finance are diversification and long-horizon mean reversion.”2 We can bet on mean reversion in bubble assets, but must never do so on a scale large enough that runaway speculation could ruin us.3