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The first half of 2022 has been the worst start to a year in over four decades. We officially entered a bear market on June 13th, and experts believe the worst is yet to come, predicting that the S&P 500 could plunge by another 25%. According to the Buffett Indicator, which is the ratio of total U.S. stock market capitalization to U.S. GDP, the stock market is about 57% overvalued as of September 2022. Other indicators, like the P/E ratio model, peg it at over 50%!

In addition, inflation doesn’t seem to be slowing, spurred on by factors including the raging war in Eastern Europe, supply chain issues, and global tensions. The U.S. Federal Reserve has been battling against inflation with aggressive interest rate hikes which have altered the entire market landscape. Moreover, Switzerland has just received its first interest rate rise in 15 years.

The events that are transpiring in the financial markets are being felt on a global scale, with high inflation and suffering markets happening worldwide.

However, it’s not necessarily all doom and gloom. There have been some recent bouncebacks, and some investors even theorize that the bear market is almost over. But other investors remain concerned about the longer term prognosis, as demonstrated by the whipsawing of the market.

The question is whether this bear market will lead to a full-blown crash, or whether we’re already in the early stages. How did we end up here? The answer is that it was all preceded by a financial or economic bubble.

1. What is a financial bubble?

Financial bubbles are based on perception. Prices and values are higher than the actual underlying value (like the S&P 500’s 40-50% overvaluation), resulting in a rapid escalation followed by a steep decline – the bubble bursts. A basic characteristic of bubbles is the suspension of disbelief by participants in the speculative surge occurring. In other words, there is widespread willful ignorance and throwing caution to the wind. Speculative demand rather than intrinsic value fuels inflated prices, and only in retrospect do most investors realize their mistakes.

The bubble burst is caused by massive sell-offs. The resulting damage can last years, depending on the economic sectors involved and whether the participation is widespread or localized. An example of this is the equity and real estate bubbles in Japan from 1989-1992 which led to a prolonged period of stagnation to the point where the nineties are referred to as the Lost Decade.

In 1987, there was Black Monday, which impacted stocks worldwide from London to Hong Kong, and Berlin to New York. In the United States, the 2008 residential real estate bubble led to severe recessions which the nation did not recover from until 2013. On the chart provided below, the bubbles can be seen bursting in the steep decline at certain points.

The stock market crash of 2008 & Black Monday 1987
Source: IG Charts

​​Economists have spent years studying financial bubbles and have identified the five key stages of a bubble. Recognizing these patterns can help investors prevent being ensnared by the facade in the future.

2. What are the main reasons financial bubbles develop?

As you may have surmised, a host of psychological and economic reasons lead to the development of financial bubbles. Many theories are based on observable human behaviors. Economists have studied and compiled some of the most prevalent problems relating to behavioral finance. Listed below are some of the chief economic conditions contributing to asset inflation as well as the behavioral influences:

Primary economic conditions contributing to bubbles:

  • Low interest rates – Low rates make it easy to borrow money cheaply, which boosts investment spending. However, because of the low rates, investors do not receive optimal returns on their investments, so they switch to higher-yield, higher-risk asset classes, causing price spikes.
  • Demand-pull inflation – This simply refers to when buyers’ demand for assets exceeds the available supply. The sellers then raise prices.
  • Asset shortages – On a similar note, perceived shortages increase the likelihood of asset bubbles because the imbalance between supply and demand leads to price hikes beyond the asset’s intrinsic value. It’s all interconnected.
  • Herd mentality – As humans, we tend to want to follow the crowd, which seems like the safest option, but the irony, in this case, is that it in fact creates danger by feeding big market swings. More volatility means more risk.
  • Confirmation bias & cognitive dissonance – Humans are skilled at tuning out that which we do not want to hear. We surround ourselves with opinions, people, and writings that validate our existing worldviews instead of being challenged. This is true for companies too – as long as other companies behave in this way too, everything is fine.
  • Hindsight bias – This phenomenon describes how people generally attribute successes to talent, but losses to bad luck. This view tends to compound with time and leads to high risk-taking behaviors rooted in a misguided belief of one's own capabilities. It’s a common mindset in gambling.
  • Fear of missing out (FOMO) – A driving incentive for investors is the fear of missing out on potential success. This is a key component of the second phase of a bubble because more players enter the game, causing the “boom”.
  • Greater fool theory – On the other side of the boom is the late-stage bubble, where investors pay large sums for overvalued assets believing they will find a “greater fool” who will pay even more for it.

The factors outlined above are some of the primary reasons leading to financial bubbles. ​Now, let’s dive into the five general stages of a bubble.

3. Five stages of a bubble

American economist Hyman P. Minsky was the first economist to come up with the theory of how and why financial markets regularly experience bubbles. Before Minsky, most economists believed that markets are inherently efficient and that bubbles are created by external factors. In contrast, Minsky believed that financial markets are inherently unstable and that debt and the psychology of the markets lead to bubbles. The 2007-08 financial crisis is when Minsky’s work was finally adopted into the mainstream. That’s why the crisis is often referred to as a “Minsky moment”.

Five stages of bubbles – the different phases and indicators of a financial bubble

According to Minsky, here are five stages of a financial bubble:

  1. Displacement of the old market paradigm
    The first stage starts to form when a new theory or paradigm takes hold in the market. This is often caused by the development of a new asset-type e.g. cryptocurrencies or a new industry e.g. railroads. No bubble is exactly the same, so as prices start to take off, naysayers are told that “this time it is different.”
  2. Boom
    As prices start to gain momentum, it attracts the attention of the herd and investors pour in. Soon, even your Uber driver has FOMO. Banks and financial institutions are also loathed to miss out and as a result, they extend credit to investors. In this second stage, the market moves from a conservative hedging approach to speculation.This can be seen in the US subprime housing bubble that crashed in 2007-08. When fund manager Steve Eisman went to Florida to investigate the property market, what he found was that mortgage brokers were selling mortgages to people with no income and jobs, buying multiple houses with 5% deposits and interest-free periods.
  3. Euphoria
    Suddenly, it seems like the world has changed and valuations are pushed into the stratosphere.GameStop’s share price went from one dollar in July 2020 to a high of USD 81.25 in January 2021 with no real change in the company’s business prospects. Members of the Reddit group WallStreetBets were convinced that through the power of social media, they could organize and take on the Wall Street funds that had shorted GameStock, and for a time they succeeded. These investors en masse forced funds to abandon their short positions. When that happened, it pushed the price up and up, but the momentum did not last long, and a sudden drop was imminent.
  4. Profit-taking
    At some point, wiser heads realize that it is time to cash in their investments before the inevitable fall. As their numbers grow, momentum starts to turn against the bubble. The central bank may also step in during this period and raise interest rates to “gently” pop the bubble. Investors start to experience difficulty in paying the higher interest rates on their debts.In the 2015 Hollywood film, The Big Short, based on the 2010 book by Michael Lewis, hedge fund manager, Michael Burry, shorted the residential mortgage-backed securities market by buying credit default swaps. When the US subprime market crashed, Burry made over USD 100 million personally and USD 700 million for his fund.
  5. Panic
    Now, the end is in sight. A not-so-unusual event catches the market by surprise and focuses the collective attention of the herd. Suddenly, there is a mass realization that the bubble is about to pop, and now the race to the bottom of the market is on.At the height of the dotcom bubble in March 2000, Dell and Cisco each put in huge sell orders on their stocks and this quickly led to widespread panic.

4. How to limit the influence of a bubble on your portfolio

We have covered the causes of bubbles and the five stages of their life cycle. Investing in public markets does not give an investor total protection, but there are ways to mitigate the damage caused by bubbles. Remember that the worst approach is to attack a bubble head-on with a stock-picking strategy. This is the antithesis of hedging against economic bubbles. Eventually, bubbles will burst and impact portfolios, but there are time-tested strategies that investors use to limit the impact.

1. Ride a bubble

Those who maintain a cool head can theoretically benefit from the low prices, which occur during and after the boom. These investors can view it as a buying opportunity. But again, it’s not about a stock-picking strategy (more on that below). Profiting from investing in a crisis requires discipline, patience, enough wealth in liquid assets available to make opportunistic purchases, and, of course, plenty of time for due diligence and tracking when to get out.

It is important to do your due diligence, and track investments so you can time when to exit. On the other end of the spectrum of catalysts, fear can drive prices below their intrinsic value, and that’s where patient investors who allow prices to revert to their expected levels will be rewarded.

Timing is crucial. Even institutional investors often fail to make the right call. For people without any professional experience, the risks may well outweigh the potential gains. Looking at data from the chart below, the numbers show that if an investor missed out on the S&P 500’s 10 best days per decade, their total returns would be significantly lower than the return for investors who waited it out. This suggests that investors should contribute to their portfolios consistently rather than trying to time the market by trading in and out with some variation on a stock-picking strategy.

The difficulties of trying to time the market
Source: CNBC

2. Short the market

Another way to make money during a crisis is by betting that a crisis will even happen. Hindsight is 20/20, but even macroeconomic events are extremely difficult to foresee. Short-selling stocks or short equity index futures is a way to profit from a bear market, but it’s also an extremely risky strategy. Essentially, a short seller borrows shares that they do not already own with the intention of selling and then buying back at a lower price. The graph below illustrates this process.

Short selling scheme

Most investors are restricted from short selling or they do not have access to derivatives markets, but if they do, they could have an emotional or cognitive bias against short selling. Additionally, short-sellers may have to cover their positions for a loss if markets rise (rather than fall) when margin calls are issued. This is a strategy that has been glamorized such as in the 2015 Hollywood film, The Big Short, but the reality is there is significant risk involved. Still, it remains a way to possibly make a quick profit just before a market bubble bursts.

3. Use an alternative investment strategy for hedging

The above-mentioned strategies are exceedingly risky. You could lose all your money, and not only that, it could drive you into debt as well. We have touched on some of the reasons for this risk already, but delving further:

  • Successfully timing the market is extremely difficult. Even institutional investors struggle to do this successfully (and consistently). Someone with no experience or training could lose everything with one bad call.
  • Investors who short stock can lose more than 100 percent of their original investment. Referencing the graph above, if the market were to rise instead, the short-sellers would be forced to cover their positions, so they could lose USD 100 more (USD 600 total in the example) instead of gaining it. Bear markets happen fast and typically do not last long because the stock market rapidly discounts a bleak future, whereas bull markets rise more slowly over time.

Back to the original question: How can you limit the influence of a bubble on your portfolio? And what can you do with all this information?

The optimal strategy to protect yourself from uncertain market conditions is to diversify with alternative assets. This can protect you from market movements headed by investors’ herd mentality.

The reasons alternative assets might work as a hedge against bubbles are as follows:

  • Alternative investments are typically less volatile and less correlated to the stock market, making them well-suited for diversification. Their reduced volatility is due to their typically long investment horizons, which require investors to commit for a set period. Valuations are also more fundamental, rather than being influenced by momentum trading or emotion.
  • Alternative investments may not just offer risk protection. They could go as far as to outperform the market. According to our calculations, if you invested CHF 1'000 in Cambridge Associates LLC US Private Equity Index in 1997 instead of the Swiss Market Index (SMI), the total cumulative return would be 1'271.97% more at the end of Q1 2022. In essence, this is the Holy Grail of lower risk as well as possibly higher returns.

Cumulative performance comparison of public and private equity (in CHF)

Moonshot Strategies is a prime example of where to drink from this so-called “Holy Grail.” Moonshot offers specially curated investment baskets, including private equity, private debt, and luxury and commercial real estate. These asset classes can offer lower volatility and more lucrative returns, as well as provide substantial diversification benefits for a portfolio already consisting of traditional assets due to the lower correlation with the stock market.

Conclusion

Hoaxes, frauds, manias, and other large-scale financial irrationalities have been with us from the beginnings of the markets in the seventeenth century, long before the Internet.” – Edward Thorp, mathematician and investor

There is no guarantee that the financial bubble will not burst tomorrow, next month, or next year. As many experts opine, speculative bubbles in some asset class or another are inevitable in a free-market economy. However, becoming familiar with the steps involved in bubble formation and strategies to protect against bubbles through diversification and alternative investments may help you spot the next one and avoid becoming an unwitting participant in it.

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