Don’t bet against bubbles, look for ‘anti-bubbles’

How do we deal with bubbles? Much study has gone into asset price bubbles and we know from the experience of the past two decades that they can do deep damage to the world economy. But what exactly is an investor to do about them?

We know from the dotcom bubble that the costs of sitting out a bubble can be serious. Many value managers saw their clients pull money from them and wished that they had joined the herd during the dotcom boom.

Meanwhile, the spectacular success of hedge fund manager John Paulson’s bet against subprime mortgages ahead of the 2008 crisis, along with the superb book and movie The Big Short, showed the returns that are there for those who directly bet against bubbles.

But Rob Arnott of Research Affiliates points out in a new paper that, shorting a bubble is a dangerous strategy. He uses the example of the little-known bubble in the Zimbabwean stock market as its currency crashed.

In the three months to October 2008, the Zimbabwean dollar plunged from 10 to 1,000 per the US dollar. In the first eight weeks of that period, its stock market gained five-hundredfold, or fiftyfold in US dollar terms. Over the next two weeks, stocks fell 85 per cent while the currency fell threefold, a 95 per cent fall for stocks in US dollar terms.

Then the currency’s purchasing power fell tenfold in a few days while stocks fell 99.9 per cent in US dollars and soon ceased to exist.

If it were possible to take short positions, someone with perfect hindsight could have grown very rich from this turmoil. Like the heroes of The Big Short, they could sell Zimbabwean stocks short. But it is not as simple as that.

Even when you can identify a bubble — and some are obvious in real time — making money is hard in the late stages, because swings can be violent, and valuations absurdly overdone.

As Mr Arnott says: “Even with the prescience of knowing the market was going to zero in three months, by selling short we would have lost 50 times our money, with high odds of bankruptcy, before being proved correct!”

Shorting is risky and expensive. Potential losses are infinite and you must pay interest to finance the position. Shorting nevertheless often makes sense but the wild conditions of a late-stage bubble are a bad time to try it.

What then to do when a bubble appears? For fund managers, Mr Arnott offers the concept of “maverick risk” — by which he means an investor’s tolerance for the gap between their manager’s performance and that of their peers.

Many investors appoint an active manager knowing that they will try to differ from the crowd and might underperform as a result. But there are limits. No fund manager should exceed them.

Put differently, active bets should not lead to high odds of underperformance larger or longer than clients can tolerate. If they do, they risk the fate of Tony Dye, the legendary London fund manager who sat out the tech bubble, underperformed, saw clients exit and was fired just as the bubble burst.

If betting against bubbles, do it carefully. Note that this means departing from the “Invisible Hand”, as fund managers, who make up the vast majority of capital in stock markets, would follow their own interests, and not those of the clients whose money they are investing.

Hence bubbles can last longer than they did when money was mostly invested by people investing on their own account.

Rather than bet against bubbles, it is better to look for “anti-bubbles”. If capital is over-allocated to assets in a bubble, then other assets have been under-allocated capital. Investors should search for sectors priced at levels that “cannot plausibly deliver anything but a large risk premium”.

Almost any single asset’s price can drop to zero but Mr Arnott points to junk bonds, financials and consumer durables in early 2009 at the market’s trough post-crisis. “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.”

Armageddon scenarios seem more plausible since the crisis. With the S&P 500 weak despite strong earnings and General Electric now apparently in danger of descending to junk bond status, they seem plausible again. But there is little to gain from a bet on Armageddon.

Mr Arnott calls this a “fool’s errand,” as no asset, even gold, is safe in an environment like crisis-torn Zimbabwe. “As with an impending car crash, we fixate on the crash, rather than looking at the paths to avoid it, and, of course, then we go in the direction we’re looking.”

There is a strong case that cryptocurrencies, and some tech stocks, are in a bubble. Rather than fixate on the disaster that could await, the best response is to look hard for the assets that have been left too cheap as a result.