In a recent issue of my Cabot Undervalued Stocks Advisor newsletter, I outlined four ingredients of a stock market bubble that were usefully outlined in a recently published book1”and briefly described how it clearly appears that our stock market is in a bubble. These ingredients include easy trading of assets, cheap and easy money, rising speculative fervor and an appealing narrative.
What makes bubbles difficult for value investors is that price and valuation become increasingly disconnected, not just for a few stocks, but for nearly all stocks. Some stock prices become complete strangers to their realistic valuation, like GameStop (GME) recently, while others distance themselves to only a casual acquaintance. In most bubbles, the disconnect goes both ways: some stocks become amazingly overvalued, others amazingly undervalued.
So, how does a value-focused investor invest during a bubble? We think there are at least four approaches.
4 Strategies for Investing During a Stock Market Bubble
The first strategy is to invest using the same strategy as in normal times. This can appear to be simpler than adapting to the bubble, but can lead to damaging mistakes. As humans, it takes immense discipline to stay the course. One example: watching just-sold stocks surge to new highs, leading investors to repurchase them in hopes of catching the next upward move. But, if a stock is overvalued at 75, it’s probably overvalued at 100.
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The second strategy is to fully exit the market by going to cash. While this has understandable appeal, as in, “I don’t understand the market these days, this thing is going to crash, so I’m out,” it can lead to wealth-damaging market timing. Too often, market timers exit years early, only to jump back in after the market continues to surge and perhaps right before a sharp sell-off. Investors tempted to exit might trim their equity exposure (but not by too much) if for no other reason than to take some edge off.
A third strategy is to follow the approach of legendary investor George Soros, who recently said, “When I see a bubble forming, I rush to buy, adding fuel to the fire.” With this approach, the investor abandons all pretenses of valuation-oriented stock-picking and instead rides the hot names. While this may work for investing legends with sophisticated risk-control processes and a team of capable traders, it isn’t a great strategy for anybody else as it can produce catastrophic losses. Nevertheless, many investors adopt this approach, aggressively putting new money into the hot names, which helps drive the bubble higher.
A fourth strategy is to invest both slower and faster. Slower, to research and understand the underlying value of individual stocks. This takes time. Yet, faster – pouncing when sentiment pushes individual share prices to irrational lows compared to their underlying value, and selling when positive sentiment pushes up prices to levels that are overly exuberant compared to the underlying value.
In general, you might hold onto your positions just a little longer than usual to capture some extra upside. And, you might leave just a little extra cash aside to protect your portfolio should the market slide. You will forgo some profits, but this extra cash provides some firepower to use if the market drops. Similarly, pay attention to your asset mix. If stocks surge, your equities will become a larger portion of your total capital base, so you may want to trim this along the way to maintain your targeted mix.
It’s valuable to spend some time thinking specifically about what you are going to do, and then write it down. Days pass only one day at a time, providing plenty of opportunity to think during a possibly multi-year stock market bubble.
- Boom and Bust: A Global History of Financial Bubbles by William Quinn and John Turner, 2020.
Editor’s Note: This post was excerpted from the latest issue of Cabot Undervalued Stocks Advisor. To read the full issue, click here.
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