March 4, 2021:
In our last article, we made the case for a major speculative bubble in US growth stocks . Below we’ll discuss how we are investing in this situation, starting with a look back at the last two major bubbles.
The tech bubble – safety in value
The US stock market declined by nearly 48% in the aftermath of the late-1990’s tech/dot-com bubble. But that’s nothing compared to the bubbliest area of the market: the tech-heavy Nasdaq 100 fell 83% from the peak and took 15 years to recover.(1)
Even as tech stocks reached indefensible valuations, though, there were many market areas that were very reasonably priced. These included US value stocks, small caps, REITS, and emerging market stocks. Those areas fell along with the overall market once the bubble burst, but the decline was shorter and smaller, and the recovery quite powerful as tech continued to struggle.
Emerging market value stocks, which were actually cheap at the peak of the tech stock bubble, provide a good example. They did fall early in the bear market, but they hit bottom a full year earlier than the US stock market, and the ensuing recovery left US stocks in the dust.
The housing bubble – nowhere to hide
Unlike the tech stock bubble, all areas of the stock market were expensive at the height of the housing bubble boom. Those areas at the epicenter of the bubble got the worst of it; the homebuilding and bank sectors both fell over 80% and took over a decade to recover. But all stocks fell hard, with the US market falling 55% and international stocks dropping even more than that.(1)
This is partly because the housing market crash had a much deeper impact on the economy than the tech bubble burst. But the bigger issue, in our view, was that everything started out expensive: there was no place to hide, at least not in the stock market.
The current bubble and how we’re investing
The current situation resembles the tech bubble much more than the housing bubble. Growth stocks, rather than housing and mortgages, are once again the focus of the bubble. And there are many areas of the global stock market that are priced far better than the bubbly stuff:
- Across all regions of the world, value stocks are much less expensive than growth stocks.
- International developed market stocks are much more reasonable than US stocks, and emerging market stocks are cheaper still.
- Combining these ideas makes them even more appealing: international developed and emerging value stocks are reasonable-to-cheap on their own, and shockingly cheap compared to US growth.
We are focused on these lower-priced areas of the stock market, and we have healthy exposure to stock investments that look priced for good long-term returns. However, each of our models has a range of potential stock exposure, and in all cases our stock allocations are lower than they could be. This leaves us room to add to our stock holdings if prices decline (whether due to a bursting of the growth bubble, or a more run-of-the-mill market decline).
Outside of stocks, bonds don’t offer much help. Yields are higher than they were in mid-2020, but still near historic lows and a major risk for those who hold long-dated bonds. Our bond exposure is smaller than usual and is concentrated in shorter-term bonds that have less interest rate risk. We’ve also incorporated several alternative strategies that don’t necessarily correlate with stocks or bonds. Some of these are designed to benefit if the expensiveness of growth versus value stocks goes back towards normal, even if this adjustment takes place in the context of a market downturn.
In short, we’re invested, as always, in the areas of the global market that seemed priced for good long-term returns. At the same time, we are trying to protect from the bubble in three ways: sticking to the cheaper areas of the markets, leaving some room to add more stock exposure, and incorporating investments that will benefit from a convergence of growth and value stocks regardless of market direction .
A few clients have asked us why we don’t sell out of stocks entirely, given that a bursting bubble in US stocks would likely drag everything else down with it. It’s a reasonable question. The very short answer is that this plan sounds good on paper, but there are a lot of ways it could go wrong. For those interested in a longer answer, we gave this topic its own article: If there’s a bubble, why not go to cash?
This is an opportunity
Late-stage bubbles can be frustrating for value investors, but when the bubble starts to deflate, that’s when our approach is most likely to really pay off. By steering clear of the bubble investments, we should avoid the severe, very long-term losses they will likely inflict in the bust. If the bubble burst causes a more widespread market panic, we can use that opportunity to buy things that have gone from reasonable to cheap, or better yet, cheap to cheaper.
A value-focused investment approach is at its most beneficial when investors’ emotions are running the show. We saw this last March, when really good valuations had us buying when a lot of investors were panicking out. Markets have reached the opposite emotional extreme now, with panic having morphed into euphoria. We believe strongly that we’ll look back on this period – and its aftermath – and be glad we stuck to our value discipline.
1 –Total return. Source: stockcharts.com (tickers SPY, QQQ, XHB)