Yes, but the whole point of a market bubble is lost if you keep it a secret!
Wall Street often has a bad habit of ignoring market bubbles. With billions of dollars in commissions at stake, the financial system would rather see Redditors try to send GameStop (NYSE:GME) to the moon than speak up. That’s what makes today’s market bubble so easy to ignore. Even though meme stocks are flashing all the warning signs, top fund managers are vocally doubling down on top stocks, expecting markets to push expensive valuations even higher.
But rather than bury our head in the sand, we should recognize the bubble for what it is: an opportunity to make supernormal returns. That’s because all market bubbles create the same rollercoaster of emotions that attentive investors can easily anticipate. And if you’re one of the few who recognizes the truth — that the weakest investments will temporarily outperform — then you’re far better equipped to play the markets and still get out before things unravel.
Are We in a Bubble? GME and AMC Stocks Say “Yes.”
Most analysts mistakenly call bubbles when valuations look pricey. But that’s misleading. Markets often look expensive because of high anticipated growth: Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and Facebook (NASDAQ:FB) shared a 600x average price-earnings ratio in 2014. (The companies would go on to add over $2 trillion in market capitalization). And sometimes, prices can stay high indefinitely; top tech firms can sport stubbornly rich valuations for decades.
In actuality, true bubbles form for a different reason: It’s when too many optimistic buyers overwhelm a market’s ability for price discovery. That happens when investors start buying with the sole intention of driving prices higher to unload their shares on someone else.
And that’s where we find ourselves today. According to a study by the Harris Poll, a quarter of Americans bought at least one share of a viral stock like GameStop or AMC Entertainment (NYSE:AMC) in January before their epic collapse. At the time, most investors realized the situation’s idiocy — 56% sold their shares the same month. But as hot money continues to pour into even hotter stocks, Robinhood investors are also getting swept up in the mania. Consider last week. As GameStop shares sank back to earth, young investors turned their attention to pot stocks and meme-related altcoins as if nothing happened. When even a minor press release can send shares of a money-losing cannabis company up 40%, why worry about losses if you can make them back tomorrow?
As the frenzy in the stock and cryptocurrency markets keep building, older investors will start feeling a sense of market bubble déjà vu. Because when earnings, financial strength or even a decent business cease to matter, it’s a sure sign that the market is reaching a state of mania.
Making Money During a Bubble
To be clear: Bubbles are terrible for society. They distort prices and swindle investors out of their life savings. Researchers have linked stock market crashes to higher rates of suicide and to untold psychological distress. And that’s why it’s important to treat bubbles carefully. Playing the game means exposing your portfolio to the risk of loss, and possibly making the bubble even worse. But since most of us don’t have the fortune to change the hand we’re dealt, we might as well know how to play the game.
So, here’s the good news: Bubbles tend to last longer than people expect. Overall markets also tend to rise when retail investors are making money, driving markets even higher — economists have already credited last year’s $1,200 stimulus checks for 2020’s market performance. And when cryptocurrency markets alone add almost $1 trillion to investor pockets in less than three months, investors will make sure their newfound wealth keeps making its way into more Reddit-fueled stocks.
This also means that marginal companies tend to outperform high-quality ones during bubbles as investors take more risks. In 1999, investors looking for the “next AOL” pushed unbelievable companies to even more unbelievable heights. FreeInternet.com became the fifth-largest ISP in the U.S. despite having no real plans to make money.
And today, a similarly predictable pattern is already brewing. In the marijuana space, low-margin growers Tilray (NASDAQ:TLRY), Aurora Cannabis (NYSE:ACB) and Sundial (NASDAQ:SNDL) have returned 200% since January — almost three times higher than wide-moat brands Cronos (NASDAQ:CRON) and Canopy Growth (NASDAQ:CGC).
Riding a Bull Market
As the 2021 bubble continues to mature, investors can expect cheap, marginal companies to keep outperforming before an eventual burst.
- Electric vehicles. Young and money-losing firms from Lucid Motors to Workhorse (NASDAQ:WKHS) will outpace stalwarts like Tesla (NASDAQ:TSLA) as investors turn to riskier bets for higher returns.
- Cryptocurrencies. Lesser-known altcoins will eat away at Bitcoin’s (CCC:BTC) dominance. Expect Bitcoin’s 70% market share to decline as lower price-per-coin alternatives rise.
- Tech. Lower-quality small-cap SPACs will see larger gains relative to profitable big-tech companies.
But these riskier investments also come with an inevitable risk of total loss. So to profit in 2021, investors need to follow the four golden rules of bubble buying:
- Focus on small firms with large potential. Most won’t survive the eventual shakeout, but these tend to outperform quality when greed runs high.
- Sell your initial stake as soon as you can. Playing with house money means you won’t lose your initial bet.
- Never double-down on any winning investment — that’s the surest way to lose a lot of money in a bubble.
- And finally, only gamble with money you’re willing to lose.
Investors who follow this advice will emerge from 2021 wealthier, healthier and happier than those who ignored the signs of a bubble. Because when the dam breaks, don’t expect blue-chip companies to remain expensive either. Tesla’s $800 billion valuation means the company will have to out-earn Apple (NASDAQ:AAPL) by 2030 to justify its worth today. And Nike (NYSE:NKE) now trades at almost 50 times EV/EBITDA, four times higher than its historical average.
If past bubbles are a guide, when the bubble starts bursting in retail-oriented stocks, the fallout will spill to blue-chip companies as regular investors yank out money.
What’s Your 2021 Game Plan?
Long-term investors have always held to a simple truth: Stay invested long enough, and the bumps eventually even themselves out. It’s held true for a hundred years and probably will for a hundred more. But market bubbles can turn even the most disciplined investors into fools. When you see your neighbors (or people online) making easy money with relatively little effort, there’s always a temptation to jump in.
Doing so means recognizing the bubble for what it is — a game of market speculation. Because when a business’ underlying value means nothing, it’s only the stock’s popularity that will drive prices higher. Keep that in mind as you learn to stop worrying and love the bubble
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.