After a remarkable run like we’ve experienced over the past two-and-a-half months, it’s natural to wonder if the good times will continue or if something more ominous is on the horizon. The end of 2020 greatly rewarded risk-takers in the stock market and may have even emboldened some to move out further on the risk curve. The emotion of making a lot of money, even if it’s only on paper, feels good and provides a noticeable boost to confidence. The current market environment certainly has euphoric elements but also continues to exhibit supportive dynamics that suggest the upward trend is still in-tact.

When something is going really well or seems too good to be true we turn our focus to what can go wrong, which isn’t a bad thing. It’s actually a healthy trait of a prudent risk manager. However, one has to be careful not to let the downside concerns disproportionately outweigh or overwhelm reality. Concerns about the run up in asset prices in recent months are increasingly being expressed in the media, newsletters and on social media.

Charts such as the following raise legitimate concerns.

Source: Yahoo Finance

Bitcoin has gone parabolic. It isn’t a traditional asset class like stocks and bonds so it’s not necessarily comparable. But it is a speculative asset and a move up like we’ve witnessed over the past two months is very exuberant by any measure.

Source: FRED

Asset Bubbles

An asset bubble is a situation where exuberance in the purchasers of an asset pushes the price up to levels unjustified by the cash flows or other metrics used to value the asset. In short, it’s a major disconnect between price and fundamentals. Modern era stock market bubbles include the 1920’s US stock market, the 1980s Japanese stock market and 1990s US technology stocks. In all three instances, prices ran up unjustifiably, resulting in significant overvaluations. The aftermath of each of these asset bubbles popping was precipitous price declines and years, if not decades, of recovery. In the case of the 1920s stock market, stock prices didn’t regain and overtake the 1929 highs until the mid-1950s. Imagine if you would have bought into the market near the peak in 1929. You would have had to wait almost 25 years just to break even on a price basis on your position.

Source: Robert Shiller

In the case of the 1980s Japanese stock market, the Nikkei (Japanese stock market index) still hasn’t returned to the peak level reached in 1989. That’s over 30 years and an investment at the peak would still be down today on a price basis.

Source: Yahoo Finance

With tech stocks in the 1990s, they peaked in early 2000 and didn’t reach that level again until mid-2015, a period of nearly 15 years.

Source: YCharts

As you can see, bubbles wreak all kinds of havoc on investment portfolios and take decades to recover losses from the bubble era peaks. This is particularly problematic for investors who are on the verge of retirement or are planning to retire within a few years of a bubble popping event. If their portfolios aren’t properly balanced, they may be forced to work longer than desired or to make unwanted adjustments to their lifestyles in retirement in order to afford being retired.

How do you know? 

Naturally when bubble speak picks up questions follow. For example, how do you know if an asset truly is in a bubble? And what should you do if you own an asset that is in a bubble?

Some use the term bubble loosely for any situation where they are unable to justify the price of an asset based on its fundamentals. Such claims can be premature and even naïve if not carefully considered within the context of all available information. Those of us who lived through the tech bust cringe at the thought of another stock market bubble as that was a painful experience. From peak to trough, the NASDAQ composite declined 78%. That’s a massive drawdown and would be painful for anyone to experience. I know several people that never invested in the stock market again after that hit.

It can be challenging to remove yourself from the euphoria of a speculative asset bubble and be objective. Bubbles usually lead to mentalities such as the price can only go up, this time is different or current conditions, which are perceived as ideal or perfect by many, will continue into perpetuity. Speculation hits extremely excessive levels as asset price appreciation accelerates often in parabolic fashion (see Bitcoin chart above). IPOs doubling and tripling on their first days of trading are another sign of excessive speculation and bubble mentality.

What should you do?

 Everybody would love to avoid the crash in asset prices that occurs after a bubble pops. The problem is you usually only know in hindsight when a bubble actually popped. Jeremy Grantham in “Waiting for the Last Dance” stated, “The great bull markets typically turn down when the market conditions are very favorable, just subtly less favorable than they were yesterday. And that is why they are always missed.” In other words, you’re not going to get out at the top of a bubble except by dumb luck.

A diversified portfolio across asset classes, geographies and investment strategies is your best bet to survive an asset bubble popping. Planned rebalancing can help by moving money from assets that have run up in price to those that have not gone up as much or perhaps have even declined. Ultimately, having a well-designed investment plan and being disciplined are what you should do in an asset bubble. Hopefully, you do not wait until the bubble is popping though. You need to be prepared from a planning perspective and from a mental perspective beforehand.

So are we in a bubble now?

Great question. A lot of smart people have gone on record affirming we are in a bubble. Investor behavior has become incredibly speculative and there is a lot of silliness in the markets right now. You have probably heard about Signal Advance. Last week, Elon Musk tweeted that people should switch to Signal (the secure messaging service). Readers of the tweet assumed Signal, the messaging service, was a publicly traded company Signal Advance, an engineering product and consulting firm. Look at the chart below. The chart shot up from $0.60 to $38.70. It is at $11.50 now. There is no new information about the company and the stock is still 3,000% higher than where it was prior to Elon Musk’s tweet. Those are the kinds of poster children bubbles are made of.

Source: YCharts

So, we’re in a bubble then?

I do not know and I’m not sure it’s important to say whether we’re in a bubble or not. It’s a label. What I’ve been telling clients and prospects is that risk is very elevated right now with asset valuations levels where they are and with the speculative fervor in the marketplace. Economic, public health and government uncertainties are also prevalent, but they always are in one form or another. Now is not the time to be aggressive. Caution is warranted here but you don’t need to head for the bunker. Remember, a well-designed investment plan coupled with discipline will provide you with the tools you need to navigate an asset bubble popping. Portfolios diversified across asset classes, geographies and investment strategies won’t be immune to the carnage from a bubble popping, but they won’t take the brunt of the drawdown either.