While there is a steady rhythm to the ups and downs of markets – since 1945, the S&P500 has seen a bear market around every five-and-a-half years – occasionally there are crashes beyond the pale, which can decimate over-exposed investors and derail established wealth goals such as retirement.
We all know the infamous examples – the South Seas bubble in the 18th century, which stripped Sir Isaac Newton of his savings, or the massive global equities crash in 1929. Recent examples include the collapse in Japanese equities and real estate in 1990 and the dot-com bubble in 2000.
But what distinguishes an asset bubble from the usual upcycle that is part and parcel of investing? Experts point to several common factors, including speculation, high levels of leverage, irrational exuberance and even “animal spirits” – meaning investor mania, madness and a single-minded belief the bubble will never end.
Asset bubbles are most commonly found in small pockets of the investable universe. In these cases, prices should exhibit “extreme outperformance versus the broader market”, says Gerry Fowler, investment director – absolute returns at abrdn (formerly Aberdeen Standard Investments). “Beyond that, you need some element of hubris, like a paradigm shift that suggests that it’s going to be a permanent shift in some relationship.”
Once a bubble pops, you typically see a full retracement of price to its pre-bubble levels, he adds.
As economists point out, there is a significant difference between an isolated asset bubble – say Bitcoin in 2018, whose 80 per cent decline hurt a handful of investors, or GameStop’s share price earlier this year – and an earth-shattering bubble such as global equities in 1929 or US housing in 2008, which impacted the broader economy, resulting in job losses, bankruptcies and foreclosures.
Are we in a bubble now?
Many financial experts believe the current stock market conditions in the US constitute a bubble, given historically high valuations.
There have been obvious signs of bubbles in pockets of the market since March last year – areas such as meme stocks like AMC and GameStop, special purpose acquisition companies, cryptocurrencies and even esoteric instruments like lumber futures, coupled with excessive risk-taking by investors.
But views are divided on whether the broader US equity market constitutes a bubble.
This summer, The International Economy asked about 20 of the world’s preeminent economists about their view on the likelihood of an asset bubble bursting.
“Pockets of excessive and, in some cases, irresponsible risk-taking have been fuelled by years of ample and predictable liquidity injections by the Federal Reserve and European Central Bank, the world’s most systemically important central banks,” says Mohamed El-Erian, an economist and president of Queens’ College at the University of Cambridge, who rated the chance of a bubble bursting at eight out of 10.
Nevertheless, other economists rate it lower. With financial assets driven higher by the monetary policy prevalent in almost all industrial countries, “this phenomenon will only disappear when central banks put their policy in reverse gear”, Thomas Mayer, founding director of the Flossbach von Storch Research Institute, says.
“But since they have become prisoners of fiscal policymakers and financial markets, I assign a relatively low probability to a meaningful tightening of monetary policy.”
Outside of monetary policy, other experts point to major shifts in technology and the re-emergence of inflation as helping to explain the historically high valuations of equities in many markets and especially large US tech companies.
“We’re going through a technological transformation, which has been accelerated by Covid-19 and lockdowns. And so that, to some degree, may justify a big shift in the relative value structure in financial assets,” says Arnab Das, global market strategist for the Europe, Middle East and Africa region at Invesco.
Technology transformations have often been associated with asset bubbles as investors look to place their bets on companies, even if it’s still unclear who will be the eventual winners, Mr Das says.
While investors during the dot-com bubble were using spurious metrics such as cash burn rate to value companies, today's valuations of US tech companies are more related to harder metrics like cashflow, as well as a clearer outlook on key technologies, he adds.
What does it mean for my portfolio?
While the prospect of asset bubbles can be scary, the good news is that a well-diversified portfolio will typically weather the storm, given that most bubbles occur in pockets of the global market.
“If you have a good wealth plan, this is something that holds for the full [investing] cycle,” says Michael Bolliger, chief investment officer of global emerging markets at UBS Global Wealth Management.
Many of the lessons about how to survive an asset bubble are also instructive for ordinary portfolio management.
One famous example is the crash of Japanese equities in 1990, a bubble that included real estate and other assets, leading to what was termed as “the lost decade”, as asset prices continued to stagnate while banks struggled to dispose of bad loans.
Although many Japanese investors were badly impacted, those holding a globally diversified portfolio were less affected, a demonstration of the risks of being overly exposed to a single country – typically their home market – when investing.
Mr Bolliger advises clients to utilise a “total wealth approach” when it comes to analysing their home market exposure.
“Often, we see that people are way too sticky in their home market. That’s something we see in the stock and bond investments in our clients’ portfolios, but it becomes much more relevant when we move away from a narrow view of financial assets to include real estate, income, pension fund money and so forth, which are often exclusively invested domestically.”
“When you take these assets into account, you may end up with a home market bias that is much more meaningful than you first think,” Mr Bolliger explains.
This is also especially significant for investors based in emerging markets, which often see greater volatility than developed ones, he adds.
Another significant aspect is time in market. An investor who dollar cost averages into an asset over a long timeframe will be far less affected by a bubble popping, compared with an investor who goes “all-in” during the final frenetic stages, especially since the long-term investor should benefit from the run-up in valuations.
The lesson for ordinary cycles is the phenomenon of portfolio drift. As equities outperform other portfolio constituents, without semi-regular rebalancing, the portfolio will drift out of balance (a 60/40 equity/bonds portfolio may become 75/25), leaving an investor over-exposed in the case of a downturn in equities.
There is also a behavioural component, Mr Bolliger says. Apart from natural portfolio drift, investors also tend to deliberately increase their equity exposure during the upswing of an investment cycle. “Both aspects require a disciplined investment approach,” he says.
Another key consideration for investors is their age, with the rule of thumb being that younger investors can take on more risk, given their portfolio should have time to recover in the case of drawdown. Investors nearing retirement, or closer to achieving their wealth goals, should look for a more stable portfolio with less exposure to equities.
How does a long-only portfolio fare?
While there are plenty of investors and fund managers who actively try to time the market, such as closing positions when assets look overvalued or even shorting the market, others believe you cannot successfully time the market and rely on positive returns on assets to grow their wealth over the longer term.
For a standard portfolio like the 60/40, as the market drops, investors will be hoping to offset losses in equities with gains in fixed income, with bonds often moving inversely to equities. Rebalancing their portfolio during a dip will limit their overall drawdown and position them to recover more quickly.
Stuart Ritchie, director of wealth advice at AES International, believes that given evidence that most fund managers fail to outperform their benchmarks over the longer term or correctly time the market, investors are best placed to use dips in the market as an opportunity to buy more stocks and wait for the recovery.
“It does take longer for equities to recover [after a crash], but if we’re not going in and having to sell equities to fund your retirement expenditure, then actually it has very little impact,” he says. “Yes, it’s scary to watch the value suddenly drop, but this isn’t unusual, this does happen and markets do fall.”
Clients must construct a portfolio around future cash needs, Mr Ritchie advises. This can include two years of expected expenditure in cash, the next three years in a portfolio weighted towards short-term government bonds and then for more than five years, the majority of the portfolio can be skewed towards equities, which is typically the asset that should be able to generate the best returns over the longer term.
While looking at a market index like the S&P500 seems to show disastrous performance following major market crashes – such as in 1929, 1973 and 2000 – often these charts don’t show the full picture, Mark Chahwan, chief executive and co-founder of digital wealth manager Sarwa, says.
While it appears the broader market index took more than 10 years to recover after 1929, these charts typically will not show the benefit of dividends received by investors holding stocks over this period.
Charts also typically show nominal returns, meaning they do not take into account inflation or deflation – namely the real value of equites in relation to spending power. Deflationary forces come into play after a market wipe out, Mr Chahwan says, whereas large growth in equities often occurs during inflationary periods, which, in effect, reduce the real returns.
Defensive sectors and instruments
For investors who believe markets are set to complete a larger correction in the near term or who are seeking greater stability in their portfolio, there is a variety of options. That includes the bread-and-butter play of investing in defensive stocks – sectors such as healthcare, utilities or consumer staples – whose revenue is typically stable even through a downturn.
UBS highlighted defensive options including hedge funds – which typically aim to provide positive returns regardless of market conditions – or approaches such as options and structured investments.
Nevertheless, it’s clear many of the more sophisticated instruments will not be “go it alone” options for ordinary investors.
“The whole is more than the sum of its parts – when we look at our strategic allocation, a client who banks with us would have exposure to all of these instruments – and more or less of these depending on where we stand,” says Mr Bolliger.
Mr Fowler recommends investors seek exposure to fund managers who have the ability to assume short positions in the market as opposed to long-only.
“For investors that are sitting in traditional portfolios that tend to just own assets, whether it’s equities or bonds, the future return environment at this point looks very low,” he says.
“But it is possible through some alternative strategies as well as the ability to use some leverage and shorting to still produce reasonably positive returns – if you’re able to short the market and you can get your timing right, then obviously that negative becomes positive.”