Investing During Market Bubbles and Bursts

I’ve recently seen a ton of headlines, blog posts and money manager commentaries discussing bubbles. Most, if not all, are written as “buyer beware” pieces, which warn about the risks of buying into markets that are bubbalicious.

The problem is bubbles aren't easily defined, and it seems as though everyone has a different definition. Some folks compare current stock market valuations to historical averages to determine a bubble. I’m not a big fan of using valuation metrics to call market tops and bottoms but that’s a conversation for another day.

Other people define bubbles by evaluating the magnitude and duration of a price move to indicate when a market is in a bubble. This type of definition is very subjective and impossible to quantify.

My favorite, albeit absurd, criteria for a market bubble is that irrational exuberance will be present. But regular readers know that I’m data-dependent and I don’t know for the life of me how to quantify “irrational exuberance.” (For more from this author, see: Why Investors Shouldn't Ignore Data.)

Needless to say, my take on asset bubbles is completely different.

Bubbalicious

Do you remember the hours of fun you had with just a container of bubble solution and a wand? If you don’t, you’re lying to yourself.

There were two things that made bubbles so much darn fun, blowing the biggest bubble possible and running around and popping them.

I feel the exact same way about asset bubbles. I love to see how big they get and I love to see them pop. Both the inflating and the eventual bursting of bubbles provide excellent trading opportunities. (For related reading, see: 5 of the Largest Asset Bubbles in History.)

At the end of the day, avoiding risks and positioning yourself for potential opportunities is what matters, the rest is just conversation. 

Dotcom Opportunity

Let’s jump in the DeLorean I borrowed from Doc Brown and do a little case study. What if I gave you the opportunity to buy the Powershares QQQ Trust ETF (QQQ), which is the exchange traded fund proxy for the Nasdaq 100 index, on December 31, 1999? Would you take that trade?

Most people say, “No way! I wouldn’t buy the biggest asset bubble in U.S. history just three months before it peaks!” Well, I can think of one reason why you would: opportunity.

First off, even if you sensed the stock market was way ahead of itself, you had no way of knowing the peak would come on March 24, 2000. If we’ve learned nothing else in the last decade, just because a market has moved up or down X percent doesn’t mean it can’t sustain that move for months to come.

During the Nasdaq bubble-bursting calendar year of 2000, QQQ went through four very distinct price action regimes. The first one lasted from the beginning of the year until the market peaked on March 24, 2000, during which QQQ gained 32%.

The second regime lasted until May 26, with the QQQ losing 40%.

The third regime lasted until September 1, with the QQQ gaining 43%. It’s important to note, the QQQ was up 12% for the year through September 1.

Then came the fourth price action regime, which lasted the final four months of the year, and whacked 44% off the value of the Nasdaq 100.

Each of those advances and declines lasted an average of 92 days, or three months.

My point is that despite being the biggest asset bubble in U.S. history (at that point in time), the bursting was a very tradeable event. What’s more, eight months into the ordeal, buy-and-hold investors still had a double-digit gain for the year and ample time to move to the sidelines before the final tsunami hit in Q4. (For related reading, see: Proof that Buy-and-Hold Investing Works.)

Don't Fear Market Bubbles

The point here is don’t fear bubbles and don’t avoid markets all together because some people believe they’re bubbalicious. Bubbles don’t pop in a day and markets never go straight up or straight down. The 2008 Financial Crisis was no different.

During 2008, QQQ went through four very distinct price action regimes once again. The first one lasted from January to March 21, costing the Nasdaq 100 17%.

However, the QQQ made up significant ground over the next five months, gaining 12% of the loss back by August 15, 2008. Seven-and-a-half months into the home stretch of the crisis and the Nasdaq 100 was off just 5%.

The real wealth destruction occurred from August 15 to November 21, with the Nasdaq 100 declining 45%. The QQQ rallied off that November 21 bottom to gain 9% by year-end.

Here again, these massive price movements lasted an average of 92 days, just like when the dotcom bubble burst. No matter how you were allocated heading into 2008, you had ample time and opportunity to reposition your portfolio before things got bloody.

Present Day

To bring this conversation full circle, let’s talk Nasdaq 100 circa 2017. Since the crisis low in March 2009, the QQQ has rallied over 500%.

Is 500% over eight years a bubble? I don’t know and I don’t really care. Not that I’m eager to jump in with a full position at tomorrow’s opening bell.

Despite the chorus singing valuation and political concerns, I’ll continue to trade U.S. technology stocks, on pullbacks, as long as the U.S. fundamental gravity remains conducive to the go-go growth sectors of the U.S. economy. Bubbles be damned.

The valuation gurus who have avoided tech stocks since March because valuations were “stretched” have missed a five-month, 8% rally. How’s that for a bubble?

Bottom Line

Words like “bubble” and “mania” make for catchy headlines. Those words sell newspapers, get blog hits and convince the seven remaining people who actually watch CNBC to tune in. The benefit of remaining data-dependent, process-driven and risk-conscious is that you always have context for the price action of any market. This gives you the benefit of knowing what to do, or not do, whether a market has experienced a 47% drop or a 500% gain.

(For more from this author, see: Check Current Economic Conditions Before Investing.)