There has been a lot of talk about the bubbles lately. Stocks are a bubble or bonds are a bubble. Dollar is a bubble or all other currencies are a bubble. Bitcoins are a bubble or fiat currencies are a bubble. Start-ups are a bubble or established companies are a bubble. The list goes on.
All I know: the only thing worse than going bust buying into a bubble is going bust selling into a bubble.
For the purposes of this post I am going to assume that you, the reader, have a way to identify a bubble.
By identifying a bubble, in some specific security or in a market, I mean knowing with complete certainty that at some point in the future this security will trade at 50% of its current price.
Knowing some like this with certainty is a tall order. But I will give you this. There are instances of obvious bubbles/dislocations, and though the financial world is probabilistic, at some point you have to go with your own reasoning.
What I will not give you, is the knowledge of the timing of the said bubble bursting and the timing of this 50% price decline occurring.
Now let’s look back at the tech bubble of 1999-2000.
The NASDAQ peaked out at over 5,000 in March 2000 only to fall later to close to 1,000. One could argue that the bubble had been already identifiable when NASDAQ reached, say, 3,000 in 1999. Certainly, it subsequently corrected by more than 50%.
So who is a worse trader – the one who bought it at 3,000 or the one who sold it short at 3,000?
I don’t know the fate of a bull: it depends on the stop-loss strategy. But I do know the fate of the bear, and it is grim.
This is the problem of all short-selling strategies. You think a company as overvalued at $100 and set a target price of $50. But what if it goes to $150 before it goes down? Are you actually going to hold the position?
The answer might be “yes” for some people. Such people usually don’t survive in the world of leverage finance – your capital, your credit lines will eventually get exhausted and your investors will flee.
Of course, you can limit your downside by expressing your bearish bets via options. But this is a treacherous path as well. Downside options tend to be expensive and decay rapidly. The view might be correct, but your timing might be off, and the options will drain your capital before paying off.
All of us want to be John Paulson, who made something like $20bln betting against subprime mortgages. My hat is off to him and his team for their excellent research and unwavering commitment.
But even the people who correctly anticipated the mortgage crisis, didn’t have an easy time of timing the collapse or finding the correct strategy to take advantage of the bubble. For every John Paulson, there are a lot bear skeletons littering financial thoroughfares.
Am I telling you that there is no way to take advantage of recognizing a bubble?
No. There is one sure way.
SIT IT OUT.
If you know that stocks will collapse below current levels, stay flat! By the virtue of being in cash, you guarantee yourself a great buying opportunity (like in 2002 or 2009) with no risk of being squeezed.
You think stocks are in a new bubble?
It is the bulls who need to charge.