Three Lessons When Investing in a Bubble

January 9, 2013

Investors must face the reality that policy makers have fueled yet another wave of financial bubbles with the twin policies of effectively 0% short-term interest rates and the printing of trillions of dollars since the crisis in 2008.  As evidence, look no further than U.S. equities, where the S&P 500 at its most expensive 10% in its history despite a poor economy.[1]  Whether investors want to admit it or not, it is a bubble market again.  Keep these three lessons in mind when navigating the waters ahead:

Three Lessons of Investing in Bubbles:

  1. Money printing can trump fundamentals … for a while.
  2. Most investors (and their advisors) are blind to bubbles on their mistaken belief in efficient markets.
  3. Bubbles can persist for longer than most think possible and then pop much harder than imagined.

Let us examine these findings.  How can stock markets rise despite poor fundamentals in an economy?  Easy, on the back of printed money and inflation.  On the surface, Venezuela’s Caracas stock market is the envy of the world, up 480% in 2013.  However, with inflation at nearly 50% and shortages of basic necessities such as toilet paper, the rising stock market is hardly indicative of a fundamentally strong economy - making it prone to a future crash.  In similar vein, U.S. equities have risen on the back of printed money and are expensive today.  Jeremy Grantham and his talented investment team at GMO have become legends in their ability to spot financial bubbles and forecast market returns.  Currently, they project US equities will deliver negative annualized returns after inflation through the year 2020, with small company stocks faring the worst.[3]   However, equities may keep rising first as the impact of printed money trumps fundamentals in the minds of investors.  After all, printed money needs to find a home. Abandoning equities entirely leaves an unappetizing list of choices such as 0% cash and inflation-prone government bonds.

The old adage that “markets can remain irrational longer than investors can stay solvent” holds today as the aggressive actions of policy makers have kept the party going.  For equity investors at the party, we recommend a strict two-drink limit.  In other words, keep a defensive mindset.  For money dedicated to equities, focus on undervalued areas like select emerging markets, high quality companies with global franchises, and tactical managers that can adjust when markets turn down.   Also, money printing is likely to fuel future inflation, but inflation-hedges are cheap and unloved today.  There is a golden opportunity to begin accumulating hard asset investments.  However, the opportunity is only available for investors who brave enough to deviate from the herd.

Equity investors need to be ready to pull back the reins as the clock strikes midnight and Cinderella dashes out the door with the printing press in hand. Investors relying on a traditional asset allocation strategy will outstay their welcome and experience the trifecta of wealth destruction following their experiences in 2000 and 2008.  Only a well-designed tactical allocation strategy, which acknowledges these dangers today, can invest with a quick exit in mind. 

What pops the equity bubble?  Any event that takes the money printing presses away and stops the party in its tracks.  Perhaps rising inflation and interest rates?

[1]       Based on the Shiller PE Ratio of 25.4X for the S&P 500 as of December 31, 2013.  This places the S&P 500 in the most expensive 9% in its history dating back to 1881, Source: PIMCO.

[2]       Based on data from the Wall Street Journal Market Data Center, December 31, 2013, Global Equity Returns Based on the DJ Global Index,

[3]       Based on GMO 7-Year Asset Class Real Return Forecasts dated November 30, 2013.  Source: GMO.