ETF Store Insight

Obvious Bubble?

October 10th, 2017 by Nathan Geraci

Nathan Geraci is President of The ETF Store, Inc. and host of the weekly radio show “The ETF Store Show“.

“If it’s obvious, it’s obviously wrong.” – Joe Granville

U.S. stocks set new record highs during the third quarter despite major hurricanes, political drama in Washington, nuclear threats from North Korea, and the Federal Reserve announcing the removal of stimulus.  Also, a key measure of stock market fear – the volatility index or VIX – remained near record lows.  As a matter of fact, 2017 is tracking as one of least volatile years in S&P 500 history.

As stocks continue their ascent, news headlines are increasingly becoming populated by a word that might send a shiver down the spine of many investors – “bubble”:

  • Bubbles Are ‘More Bubbly’ Than Ever, Warns BAMLSeptember 5th, Bloomberg
  • Gallo Sees ‘Asset Bubbles in the Market Everywhere’September 11th, Bloomberg
  • Legendary Investor Julian Robertson Warns of Bubble Trouble – September 12th, Institutional Investor
  • It’s possible the stock market could be in a bubble, says ex-Wells Fargo CEO KovacevichSeptember 19th, CNBC
  • This chart shows how the stock market is ‘smack dab at the heart of bubble territory’September 21st, MarketWatch

Successful investors tend to view markets with a healthy dose of skepticism.  No investor wants to relive the dotcom bubble or financial crisis.  The further stocks climb, it seems only natural that investors become more concerned that the “next shoe could drop” and begin to consider whether dialing back risk in their portfolios is the most prudent course of action.  “Don’t get left holding the bag”, investors surmise.  However, there is an interesting aspect to the current market environment that bears mentioning:  historically, stock market bubbles are marked by euphoria where investors throw caution to the wind and trade stocks tips with their taxi (or now Uber) driver.  Bubbles are not typically accompanied by a seemingly common opinion that we are actually in a bubble.  So, what is the real consensus market opinion right now?  If the stock market is surging ahead without fear, is the investor consensus predominately bullish?  Or, is the market consensus the growing cacophony of investors claiming the stock market is in a bubble?  The skeptical investor in us is wondering whether the “contrarians” are actually the consensus.

Investopedia defines contrarian investing as “a type of investment strategy distinguished by buying and selling against the grain of investor sentiment during a specific time.”  They go on to say, “Many contrarians have the view of the market as an eternal bear market.”  We might suggest this definition has actually flipped, with contrarians now viewing stocks as an endless bull market.  The new consensus seems to constantly predict the market’s demise.  It is within this context that we think taking a contrarian approach to investing will yield greater success.  While there is obviously no such thing as an endless bull market (much to our dismay), until there is euphoria, investing against the grain and staying the course is the more sensible investment approach.  But why?

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

The dotcom bubble and financial crisis undoubtedly left deep psychological scars on large numbers of investors, causing them to invest much more conservatively than normal over the past 8+ years.  According to a recent Wells Fargo/Gallup poll of U.S. investors, 26% said they still haven’t bounced back financially from the stock market downturn in 2008 – 2009.  Furthermore, 54% expect a decline this year that will wipe out significant gains.  This bearish sentiment has led to substantial underperformance, both from individual investors and professional money managers.  As stocks continue surging ahead, market pessimism only seems to magnify with each new record high.

Claims of a stock market bubble may very well be proven “correct”, but at what price?  And, are investors making these claims really “right” if they attempt to prosecute this case for years on end?  Looking back at the history of the S&P 500, there have been declines of at least 19% in every decade since the 1920s – in some cases, multiple times in the same decade and with much greater than 19% losses.  Sharp stock declines happen with regularity.  It’s not really going out on a limb predicting a significant market pullback.  Unfortunately, there are behavioral biases engrained in all of us resulting in a natural tendency to preoccupy ourselves with the monster we can’t see or don’t know.  There is a reason fear sells in the financial media (which some opportunistic money managers have picked up on).  Have you ever noticed that CNBC runs primetime market specials when stocks decline by 3%, but not when stocks rise by 3%?  A movie, The Big Short, was made based on investors betting big against the housing market and stocks in 2007.  We are still waiting for the movie on the investor who bet big on stocks in March of 2009.

The problem with investing based on fear is the price you pay is ultimately dear.  Even if you had bought stocks at the exact peak of the market in October 2007 and held throughout the financial crisis, including the full 55% drawdown through March 2009, you still would have doubled your money through the end of September!  Waiting for the next shoe to drop can be a costly investment strategy.Source: @EconomPic

“Successful contrarian investing requires us to live with discomfort, for being “wrong” and alone.” – Robert Arnott

There are several important takeaways here:

  1. If everyone is claiming there’s a market bubble, there probably isn’t one. If we were in a bubble, you likely wouldn’t know it.
  2. Successful investing usually feels uncomfortable. Making money in any aspect of life typically requires hard work and perseverance.  As they say, “if it was that easy, everyone would do it”.
  3. Don’t let the financial media derail your investment plan. Staying current on market information can be educational, but taking meaningful portfolio action based on news flow is dangerous.
  4. Take only the risks you are comfortable with in your portfolio. If you can’t behaviorally or financially withstand the downside of an investment, stay away from it.
  5. Maintain the proper investment temperament.  Being too bullish is never a good thing, nor is being too bearish.  The Wall Street Journal’s Jason Zweig recently said, “You can’t survive a market crash if you think it can’t happen.”  We would add to that:  “you can survive a bull market if you think it can happen”.