Here’s How to Deal With Market Bubbles

There’s a certain exuberance in markets right now.

Bitcoin is surging to new records. Gold is, in its quaintly doddering manner, setting new records. Japan, the market that time forgot, is setting new records. The UK, ever the lovable laggard, is not setting new records (yet), but the pound — a classic “risk-on” currency — is doing unusually well this year.

So it’s little wonder that the term “bubble” is being kicked around more than usual. And it makes sense that the chat centres on the US, the one market to rule them all, which is also setting new records.

The latest burst of excitement — the one that helped gold and Bitcoin storm to new heights on Friday — was driven by the latest US nonfarm payrolls data.

On balance, although the overall data was hardly weak, there are glimmers of fragility that leave the door open to the Federal Reserve cutting interest rates.

So are we in a bubble? And does it matter if we are?

Bubble or Bull Market Bitterness?

I have to say that over the years I’ve become wary of bubble debates. It’s far too easy to point to a furiously rising market and say “it’s a bubble!” Often this is an accusation tinged with sour grapes. As my old friend Dominic Frisby has mentioned a number of times, “a bubble is just a bull market in which you don’t have a position.”

All-time highs sometimes are followed by massive collapses. But a far more frequent occurrence is that an all-time high is followed by another all-time high. This is a useful lesson in itself for an investor to learn — don’t be put off buying a given asset just because its price has never been higher. You need a better reason than that.

That said, when bubbles do pop, the downdraft can be pretty dramatic. And if they are systemic bubbles — as in, 2008-style bubbles that end up collapsing the entire economy — you probably want to be aware of them.

So, for what it’s worth, here’s my view. Is the US market expensive? Yes. It has been for ages and ages. So that’s a pretty useless metric. Has it come a long way in a short time? Yes. As the Deutsche Bank analyst team points out, the S&P 500 has risen by 21.5% in the four calendar months from the end of October. That’s a lot.

In fact, this only ever happens under two scenarios. One was during the dotcom bubble. “Aha!” I hear you say. But on the other occasions that this has happened, it was when the US economy was emerging from recession.

Now, I realise the US hasn’t been in recession. But everyone has been talking as though it was and at one point it was viewed as a foregone conclusion. So I think you could very easily put this rally in the “post-recession” camp.

If that’s the case, say the Deutsche team, then there’s no obvious need to worry about the scale of the rally, because in previous non-bubble examples, the market has gone on to enjoy double-digit returns over the proceeding 12 months.

How to Deal With Bubbles

I acknowledge here that I am a value-orientated investor and someone who has felt that the US is rather too expensive for comfort for a long time. But at the same time, I also feel that the prevailing mood is so grim — and governments so indebted, and thus more inclined to accept inflation — that a “Roaring 2020s” scenario is also very plausible.

I honestly think that the only sensible way forward for your average investor is to have some exposure to each camp. After all, that’s the whole point of diversification.

So if you’re feeling edgy, then take a look at your portfolio, and compare it to your “ideal” asset allocation. If you find that you are now holding a much bigger percentage of US stocks, or gold, or even Bitcoin than you feel comfortable with, then rebalance your holdings.

You can do that either by actively taking profits in some of the areas where you’ve done very well, or if you’re a regular investor, simply allocate a chunk of your future investments into areas that are lagging behind.

It’d be wonderful if we could know for sure when a market is heading for the top, but no one can predict the future. Frankly, in my experience, calling a bottom is much easier — pessimism has its limits, whereas optimism can just keep hanging on in there for far longer than you could imagine. Which is a good thing, overall.

But either way, while bubble spotting is fun and something market commentators will never shy away from, as investors, it’s best just to accept it as background noise, and get on with focusing on more mundane yet practical things, like making sure you save regularly and that your asset allocation and choice of investment vehicle are right for your needs.