Blowing Bubbles. Big, Magic Bubbles

I’ve seen a lot more headlines, blog posts, manager commentaries and articles discussing bubbles in the last month. Most, if not all of these articles are written as “buyer beware” pieces, which warn about the risks of buying into certain markets.

The problem is that bubbles aren't easily defined and it seems as though everyone has a different definition. Some folks talk about valuations, current versus historical averages. The problem is, that approach is only applicable to equity markets and nothing else.

And I’m not a big fan of using valuation metrics but that’s a conversation for another day. Other people look at the magnitude and duration of a particular price move to indicate at one point a market is considered to be in a bubble. This type of definition is very subjective and hard to quantify.

My favorite absurd criteria for a market being in a bubble is that irrational exuberance will be present. Maybe irrational exuberance is like porn and you know it when you see it. If not, how do you quantify “irrational exuberance?”

Even if the market agreed on a set definitions for what makes a bubble, it would tell you nothing about when the bubble would pop or how long it would take that market to work off the excesses.

My take on asset bubbles is completely different.

Do you remember the fun that could be had with a container of bubble solution and the bubble wand? If you don’t you’re lying to yourself.

What was fun about blowing bubbles? It was two things specifically and they were both equally enjoyable. First, it was fun to see who could blow the biggest bubble. Second, it was fun to run around popping all of the bubbles that had been blown.

Asset bubbles are no different. I love to see how big a particular market’s bubble can get and I also love to see that bubble pop. Both provide excellent opportunities for profits.

At the end of the day, profits are what matter and the rest is just conversation. I always laugh a bit when these bubble articles start coming out en masse. I’m inclined to go towards a market and get more interested in it when people start to say it’s in a bubble. That doesn’t mean that I get involved right away but I actively seek an opportunity to get involved with a trade idea that's skewed in my favor.

Let’s do a little case study. What if I gave you the opportunity to buy the NASDAQ 100 (QQQ) on December 31, 1999? Would you take that trade? 

Most people say “No way. Why would you want to buy an asset that was clearly frothy just months before the bubble burst?” I can think of one reason -- profits.

Even if you sensed that things were a bit ahead of themselves, you had no way of knowing that the peak would come on March 24, 2000. And if we’ve learned nothing else in the last decade, just because a market has gone up or down X% doesn’t mean it can’t move a lot more in that same direction over a period of months or years despite people calling it a bubble.

Here is a breakdown of the opportunity set that QQQ provided during the bubble bursting year of 2000:

12/31/1999 – 3/24/2000 = 32%

3/24/2000 – 5/26/2000 = -40%

5/26/2000 – 9/1/ 2000 = 43%

9/1/2000 – 12/31/2000 = -44%

These advances and declines lasted anywhere from 2-3 months and provided a total opportunity set of 159%. I’m not saying that you could have caught the top and bottom of all 4 of these moves in real time. I’m simply pointing out that you could have easily traded the bursting of one of the all-time biggest asset bubbles in US history for profit.

Even if you were a buy and hold investor at that time. You could have bought QQQ on December 31, 1999 and had a 13% gain on September 1 or been breakeven as of October 1, 2000. You could have bought a market that had already gained 200% in proceeding two years, made 32% in the first 3 months, made 13% in the first 9 months (after the bubble popped) and still been breakeven on the position in the first 10 months.

The point here is don’t fear bubbles and don’t avoid markets all together because some people are calling them bubbles. Bubbles don’t pop in a day. The bigger the bubble, the longer it takes for the markets to work off the excess.

The Financial Crisis in 2008 was no different. QQQ declined 20% in the first 3 months of the year, gained 23% over the next 3 months and then declined 47% over the next 5 months before rallying by 12% the final month of the year. These are massive price movements that occurred over a minimum of 3 months, not 1 day.

Again, I’m not implying that anyone could have known how bad things were going to get or when they were going to get bad. I’m simply pointing out that no matter how you were positioned heading into The Crisis, you had ample opportunities to get out or reposition your portfolio before things got bloody.

To bring this conversation full circle, let’s discuss the current day Nasdaq 100, QQQ. Ithas rallied an impressive 255% since the March 2009 lows (it should be noted that the S&P 500, SPY, is up 213% over that same time period).

Is 255% over a 5-year time period a bubble? I don’t know and I don’t really care. That said, I’m also not overly eager to jump in right at tomorrow’s open with a full position in my fund. What I'm saying is that if QQQ declines 8-15% from here or breaks out and closes above its recent high of 91.15 for three consecutive days; then I would be very active in putting money to work in this market.

I certainly could turn out to be wrong. If I buy QQQ after a 15% decline, that decline could turn out to have been the beginning of a significant move down. And if that was the case, I would have ample time and opportunity to correct my trading mistake and reposition myself, if appropriate.

The point is, I’m not going to avoid a market just because it's up 40% more than the S&P 500 over the same time frame and there is a groundswell for 5 weeks saying its Bubbalicious.

Words like “bubble” and “mania” make for catchy headlines. Those words sell newspapers, get site hits and get the 7 remaining people who watch CNBC everyday to tune in. But unless you’re trying to be Babe Ruth or Captain Market Timer, calling the top of every market, those words have no place in your investment process.

Your process should be the same after a 255% rise as it is after a 47% decline. As an aside, there's extra credit available for those readers who can tell me what movie today’s report title comes from. 

Hint: It was the line of a song in a movie that was released in 1972.