The trend is your friend, even when it is a bubble. Markets tend to move to extremes, so bubbles have always been part of the financial landscape. You can find books or articles about the Dutch tulip mania in the 1630′s or about John Law and the South Sea Bubble in 1720 with a quick Google search. Og the caveman probably lost money in the Great Wheel Bubble of 2000 BC. It’s not a new phenomenon.
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Given that bubbles are going to be around, what should you do about it? It turns out that when some asset class blows through its so-called fundamental value, the best way to play it is to overweight it! The evidence comes from a paper, Riding Bubbles, by academics in the Netherlands and New Zealand. From the abstract:
We empirically analyze rational investors’ optimal response to asset price bubbles. We define bubbles as a sudden acceleration of price growth beyond the growth in fundamental value given by an asset pricing model. Our new bubble detection method requires only a limited time-series of historical returns. We apply our method to US industries and find strong statistical and economic support for the riding bubbles hypothesis: when an investor detects a bubble, her optimal portfolio weight increases significantly. A dynamic riding bubble strategy that uses only real-time information earns abnormal annual returns of 3% to 8%.
The paper suggests that Keynes knew what he was talking about when he said that markets could remain irrational longer than you can remain solvent! Instead of avoiding bubbles, maybe you should go hunting for them. And trying to short the bubble is not the optimal strategy:
Riding bubbles is an attractive strategy for investors who have information only on past returns. Our results show that it is not optimal for rational arbitrageurs to exert a correcting force on prices during bubbles. Instead, our empirical findings confirm the theoretical predictions made by Abreu and Brunnermeier (2003) and De Long, Shleifer, Summers, and Waldmann (1990b) that it is optimal for rational investors to ride bubbles and thereby fuel them. Therefore, markets will not resolve bubbles by themselves.
You are better off going with the flow, rather than trying to fight the bubble. The unspoken truth is that for every famous hedge fund manager who got the big short right, there were five who rang the register on the way up—and five who went belly-up trying to short too early.
Relative strength is one of the best ways to exploit bubbles. Of course, just because an asset class is strong does not mean it has exceeded its fundamental value! Much of the time strong stocks have well-justified valuations. But on those occasions when something is strong due to some kind of fad or temporary phenomenon, relative strength will also identify it and allow you to go with it. Thus, relative strength is a rational strategy to use whether the asset in question is in bubble mode or not. Happy hunting.
