»Profit Hunter by Equitymaster

On This Day - 8 MARCH 2021
The Bubble Noise is Getting Louder. Should You Be Fearful?

Rahul Shah, Editor, Profit Hunter

Ray Dalio, the billionaire investor has made a career out of studying bubbles.

In fact, as per his own admission, he has lived through quite a few of them. This gives him a rare expertise on the topic. He is someone whose views on bubbles shouldn't be taken lightly.

I was all ears when he published his latest piece on LinkedIn. It's titled 'Are we in Stock Market Bubble?' Dalio gave a rare peek into his bubble tracking system.

He measures the size of the bubble using the following six metrics.

  • How high are prices relative to traditional measures?
  • Are prices discounting unsustainable conditions?
  • How many new buyers (i.e. those who weren't previously in the market) have entered the market?
  • How broadly bullish is sentiment?
  • Are stocks purchased being financed by high leverage?
  • Have buyers made exceptionally extended forward purchases (e.g. built inventory, contracted forward purchases, etc) to speculate or protect themselves against future price gains?

The stats relating to each of these six influences are mixed into a fancy algorithm which then spits out the final score.

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Well, I will spare you the details and come straight to the point.

As per his system, the aggregate bubble gauge is around the 77th percentile today for the US stock market overall.

Just to put things in perspective, in the bubble of 2000 and the bubble of 1929, this aggregate gauge had a 100 percentile read.

Thus, as per Dalio's system, the stock markets are certainly stretched. However, they seem to be nowhere near the craziness that precipitates a big stock market crash.

So it looks like the game can continue for some more time.

Another popular measure for spotting a stock market bubble is the famous CAPE multiple (Cyclically Adjusted Price to Earnings), designed by Professor Robert Shiller.

A recent article on Bloomberg pegs this at a little over 35 times earnings. As per estimates, it's the only second time in history that the CAPE has gone this high. Signs are certainly more ominous as per Shiller's system than Dalio's.

To be honest, there's no dearth of such systems that make investing look like rocket science.

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Don't get me wrong. I have the highest respect for people like Dalio and Shiller.

However, trying to identify whether something is a bubble and how long before it bursts, are activities where success is not guaranteed.

It's like spending a lot of time trying, valiantly and effectively, to do things that can't be done well.

Now, this presents a very interesting dilemma.

If it can't be predicted with certainty as to how big the stock market bubble will become or when will it burst, then how do we navigate this tricky stock market?

Well, here's something that you will do well to remember for the rest of your investment lifespan.

When it comes to investing, always consider probabilities and not certainties.

Never be completely out of the market even if you are very sure that the stock market bubble is about to burst.

Likewise, never be completely in the market even if you strongly believe that the market has finally bottomed.

Here's how you should position yourself...

If you have Rs 100, invest Rs 25 each in bonds and stocks.

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And put the remaining Rs 50 into either of these, based on what you think will do well over the next 12-18 months.

If you think stocks will do well, you can have stocks and bonds in the ratio of 75:25.

And if you think stock are expensive, you can reverse the ratio to 25:75.

Alternatively, you can have 50:50 in both and rebalance it at a pre-determined frequency.

This approach does not require any fancy algorithm nor does it depend on complex ratios such as the CAPE.

Yet, it is mighty effective. It does the basic job of getting you into stocks after a market crash and getting you out of it after it has gone up a great deal, quite well.

And this is what you need at the end of the day.

Your returns over the long term will depend to a great extent on your asset allocation. You need to be into stocks when they fall and you need to book some profits after they go up.

This system is arguably the simplest way to handle these movements.

Try it out. I am sure you will start worrying less about what the stock market is going to do and focus more on what you need to do.

And this is how it should be, always.

Good Investing,

Rahul Shah
Rahul Shah
Editor, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)

PS: On 16 March, Richa Agarwal, our smallcap guru, will be online at the Smallcap Fortunes Summit. She will be talking about the best smallcaps in the market today. Join Richa online by signing up for free.

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