Great article:
https://www.researchaffiliates.com/en_us/publications/articles/668-yes-its-a-bubble-so-what.html?evar36=eml_Bubble_0418_Section_1_Bubble_CTA&_cldee=anRhbW55QHJlYWxjbGVhcm1hcmtldHMuY29t&recipientid=contact-e6289710c8cbe2119aa7005056bc3cff-5f875b2cd34d
https://www.researchaffiliates.com/en_us/publications/articles/668-yes-its-a-bubble-so-what.html?evar36=eml_Bubble_0418_Section_1_Bubble_CTA&_cldee=anRhbW55QHJlYWxjbGVhcm1hcmtldHMuY29t&recipientid=contact-e6289710c8cbe2119aa7005056bc3cff-5f875b2cd34d
Quote:
- The word "bubble" is tossed around with abandon. We offer a rigorous definition for the word, and then test the definition against current markets.
- Several bubbles are evident today, most importantly a tech bubble, eerily similar toalbeit narrower thanthe "new economy" dogma of the 20002001 dot-com bubble. We also see a bubble brewing in cryptocurrencies and micro-bubbles in select stocks such as Tesla.
- Investors can take action to protect their portfolios and potentially benefit from the bubble by reducing exposure to bubble assets; seeking out exposure to anti-bubbles, where assets or markets are irrationally cheap; investing in value-based smart beta strategies especially in European and emerging markets; and avoiding capitalization-weighted index funds, which inherently overweight the bubble assets.
- Finally, we must be patient. Bubbles typically continue longer than expected, until they suddenly pop.
Quote:
By their very nature, the underlying conditions of a bubble are expected to continue or the bubble would collapse immediately. Investors, however, can go their own way by not participating in the bubble. We recommend four actions an investor can take to protect themselves and even benefit when the bubble eventually bursts:
- First, an investor can materially reduce or eliminate their exposure to bubble assets. If we cannot construct a reasonable scenario in which the bubble assets could offer an acceptable risk premium, the "greater fool" rationalesomeone will pay more for it laterresembles picking up nickels in front of a steamroller; at a minimum, we can underweight these assets.
- Second, an investor can seek anti-bubbles in the market and invest in them. Anti-bubbles are sectors or markets priced at levels that cannot plausibly deliver anything but a large risk premium. An anti-bubble cannot exist in a single asset because almost any asset's price can drop to zero. But consider junk bonds, financials, and consumer durables in early 2009. Each failure of a single company meant that the survivors in that sector had less competition, higher margins, and a clear runway. Collectively, the sector itself couldn't fail to deliver a very large risk premium, barring a handful of Armageddon scenarios.11 EM value stocks in early 2016 were a similar example. RAFI in emerging markets fell to a Shiller PE of 5.6x, an earnings yield of 18%. In a world of zero-yield bonds and cash, EM value was an obvious anti-bubble. Similar to the trajectory of a bubble, an anti-bubble continues to collapse, until it turns. Therefore, averaging into our positions, with an eye toward not exceeding the investor's tolerance for maverick risk, is a prudent way to invest. As with bubbles, the quest for the market-turning catalyst is intellectually challenging and fun, but not terribly useful. An anti-bubble can be a rich source of profit for the patient investor.
- Third, an investor can diversify into investments that are not in bubble territory. For example, as of early 2018, EM equities and many developed-country stock markets are trading at discounts to their historic valuations rather than the extravagant premium of the S&P 500. As Arnott, Kalesnik, and Masturzo (2018) noted, many arguments have been advanced to justify a US CAPE ratio of 33x. Each of these arguments applies equally to the European and emerging markets, which sport CAPE ratios less than half as expensive as those in the US market.12 For example, if low yields in the United States justify high CAPE ratios in the United States, then why do zero yields in Europe lead to a CAPE ratio of 16x? Other markets offer better places to take on market risk. Seek them out.
- Fourth, an investor can remember lessons learned from past bubbles, such as the collateral damage done to the technology-led capitalization-weighted indices. The S&P 500 was savaged in the aftermath of the dot-com bubble, down 23.4% over the 24 months from March 2000 to March 2002, on its way to an eventual 49% decline just six months later. While tech stocks were in free fall, the average US stock rose 7.0% over the same two-year period, then suffered a short,13 sharp 36% bear market. For most stocks, the bull market of the 1990s ended not in 2000 when the tech bubble burst, but in March 2002.
Today, in the US market, value stocks are trading at quite attractive levels, especially in comparison to growth stocks. This is even truer in international markets, and the growthvalue spread in emerging markets is very near an all-time extreme. If investors significantly reduce equity allocations away from traditional market-cap exposuresespecially in the United Statesand into value-based smart beta strategiesespecially in the "half-priced" European and emerging marketsthey are likely to enjoy significant insulation against the next eventual-but-inevitable market downturn.